This article appeared in AToL on May 2, 2010 as: Public
Debt - Prudence and Folly
Recently much noise has been made by fiscal hawks about the
danger of high fiscal deficits and national debts. Yet the purported
danger
comes not from the size of the deficits or debt, but on how the
proceeds from
them are used. In recent decades, the US
economy has suffered from such proceeds being spent on programs that
were not
conducive to sustainable economic growth or constructive to economic
health.
During the course of World War I, US
national debt
multiplied 27 times to finance the nation’s participation in war, from
$1
billion to $27 billion. The US
military drafted 4 million men and sent over a million soldiers to France,
solving the domestic unemployment problem overnight plus putting women
into
factories and creating a sharp rise in aggregate demand as troops had
to be
supported at a level of consumption exponentially higher than civilians
could
through market forces in peacetime. War was a blessing to the US
economy as military demand put US industries humming at full capacity
while the
homeland was exempted from war damage.
Far from ruining the US
economy, war production financed by public debt catapulted the country
into the
front ranks of the world’s leading economic and financial powers,
because the US
homeland was not affected by war damage and civilian consumption was
curbed in
the name of patriotism. The national debt turned out to be a blessing,
because a
good supply of government securities provided for a vibrant credit
market and
public sector spending created the rise in demand that private
companies could
satisfy profitably with a guaranteed market.
The truth is that the positive economic functionality of the
national debt rests not so much on its level, high or low, but on how
the debt
is expended. When the national debt is use to expand economic
production with
full employment and rising wages, it will produce positive economic
effects.
But if the national debt is used to finance speculative profits
achieved
through pushing down wages via cross-border wage arbitrage, or to
structure
ballooning interest payments to service old debts by assuming more new
debts,
it will eventually drag the economy to a grinding halt by a crisis of
debt
implosion.
World War I raised the federal debt to $27 billion, about
34.5% of GDP to produce a vibrant productive economy of full
employment. In
March 2009, the Congressional Budget Office (CBO) estimated that US gross debt will rise from 70.2% of GDP
in 2008 to 101% in 2012, while the economy is expected to stay in
open-ended
recession with unacceptably high unemployment at over 10%. The
difference is
that in 1919 the federal debt was used to finance war production while
in 2012
the public debt is expended to refinance the speculative debt bubble.
Less that a decade after the war, by 1928, US
gross debt fell to $18.5 billion, but the money so released was
absorbed mostly
by speculative profit to cause the market crash in 1929. In 1930, a
year after
the crash, US
gross debt fell further to $16.2 billion under President Hoover’s
balance
budget and the Fed’s tight money policy under Chairman Roy
Archibald Young.
During Young’s term in office as Chairman of the Fed there
was confrontation between the Federal Reserve Board and the Federal
Reserve
Bank of New York under George L. Harrison of how to curb speculation
that lead, inter alia, to the stock market boom
of the late 1920s. The Board was in favor of putting “direct pressure”
on the
lending member banks while the Federal Reserve Bank of New
York wanted to raise the discount rate. The
Board
under Young disapproved this step, however Young himself was not fully
convinced that the policy of using pressure would work and refused to
sign the 1929
Annual Report of the Board because it contained parts favorable to
this
policy. Eugene Isaac Meyer
was appointed by Herbert Hoover to be Chairman of the Fed on September 16, 1930. Meyer
strongly
supported government relief measures to counter the effects of the
Great
Depression, taking on an additional post as chief of the Reconstruction
Finance
Corporation (RFC), modeled after the War Finance Corporation of World
War I.
The RFC gave $2 billion in aid to state and local
governments and made loans to banks, railroads, farm mortgage
associations, and
other businesses. The loans were nearly all repaid after the
Depression. RFC
was continued by the New Deal and played a major role in containing the
Great
Depression and setting up the relief programs that were taken over by
the New
Deal in 1933.
Upon Franklin D. Roosevelt’s inauguration in 1933, Meyer
resigned his government posts. Months later, he bought the Washington
Post at a
bankrupt auction and turned it into a respected and profitable
newspaper. His
daughter, Katherine Graham, was publisher of the Washington Post when
it
exposed the Watergate scandal that led to the resignation of President
Richard
Nixon on August 9, 1974.Meyer was appointed by President Truman after
WWII to be the first president of the newly formed World Bank.
After the launching of the New Deal in 1933, US gross debt
rose to $62.4 billion, at 52.4% of GDP. By 1950, WWII had pushed US
gross debt five folds to $356.8 billion but only at 94% of GDP. After
1950, US
gross debt fell steadily as a percentage of GDP to a low of 33%, with a
nominal
value of $909 billion in 1980 under President Jimmy Carter. Since then,
US
gross debt had not fallen below 56% of GDP. Projected US
gross debt for 2011 is $15.7 trillion at 101% of GDP. Much of the debt
money in
the two years since the credit crisis has ended up in the wrong pockets
of
distressed financial firm but not the needy public, depriving the US
economy of full employment with rising wages to increase aggregate
demand.
While US
public debt in 1946 reached $300 billion, at 135% of GDP, the post-war
years
were prosperous years for the US.
These data show clearly that it is not the level of the public debt,
but how
the debt money is spent that determines its impact on the economy.
The Issue of Fiscal
Deficit Sometimes a large fiscal deficit can help
actually reduce its share of the GDP if the fiscal deficit generates a
bigger GDP.
The Federal fiscal deficit in 1919 was 16.8% of a GDP of
$78.3 billion. Between 1920 and 1929,
the Federal budget had a small
surplus, while the GDP grew to $103.6 billion in 1929. After the 1929
crash,
the 1930 GDP fell $12.4 billion, about 12%, to $91.2 billion, while the
Federal
budget under Hoover still
had a
surplus of 1% of GDP.
Not until Franklin D Roosevelt came into office in 1933 when
the GDP had fallen by almost half to $56.4 billion that the Federal
deficit
jump to 3.27% of GDP in 1934. All through the New Deal years, the
Federal fiscal
deficit stayed below 5% with the average annual deficit at around 3% of
GDP and
did not rise until after the USentered
WWII and peaked at 28.1% in 1943, 22.4% in 1944 and 24.1% in
1945 but
falling to 9.1% in 1946 when the GDP was $222.2 billion. once of the
reasons that the New Deal had not been as effective as could be was due
to Treasury Secretary Henry Morganthau's warning to FDR to reduce
Federal spending to avoid a large fiscal deficit. The war time Federal
deficit in 1945 was 24.1% of a GDP of $223 billion. Despite a high
fiscal
deficit, US GDP kept rising after the WWII to $275.2 billion in 1948
with a
fiscal surplus equaling 4.3% of GDP. The 2010 Federal deficit is
project to be
10.6% of a GDP of $14.6 trillion.
The total Federal fiscal deficit for the four years of WWII
was about 100% of the average annual GDP of the same period. At the
same time,
the US
grew to
be the strongest economy of the world because the fiscal deficit was
used to
finance war production, not to bail out distressed financial
institutions and inefficient
industrial firms. US
fiscal deficit for FY2009 was more than $1.75 trillion -- about 12.3%
of GDP,
the biggest since 1945. According the White House Budget Office, the
cumulative
fiscal deficit between FY2009 and FY2019 is projected to be almost $7
trillion.Total
gross Federal debt in
2008 was $10 trillion, projected to rise to over $23 trillion in 2019.
Debt
held by the public is projected to rise from $5.8 trillion in 2008 to
$15.4
trillion in 2019. Interest expense in 2008 was $383 billion. Projection
is
expected to rise as both debt principal and interest rate are expected
to rise. But what the WHBO did not mentioned was how big the GDP
would
be if the fiscal deficits were to be spent to stimulate constructive
developments. The Issue of
Inflation
Inflation is a different story. Moderate inflation is
necessary for optimum economic growth, provided the burden of inflation
is
equally shared by all segments of the population, particularly wage
earners. By
the end of World War I, in 1919, US prices were rising at the rate of
15%
annually, but the economy roared ahead as wages were rising in tandem
with or
slightly ahead of prices through wage-price control.
Income policies involving wage-price control were employed
throughout history from ancient Egypt,
Babylon
under Hammurabi, ancient Greece,
during the American and French revolutions, the Civil War, World War I
and II.
A case can be made that that wage-price control has a mixed record as a
way to
restrain inflation, but it is irrefutable that income policies are
effective in
balancing supply and demand.
Yet in response to inflation, the Federal Reserve Board
raised the discount rate in quick succession in 1919, from 4% to 7%,
and kept
it there for 18 months to try to rein in inflation by making money more
expensive when banks borrowed from the Fed. The result was that in
1921, 506
banks failed.
The current financial crisis started in late-2007 and
stabilized around mid-2009 after direct massive Fed intervention. It
was by
many measures an unprecedented phase in the history of the US
banking system. In addition to the systemic stress and the stress faced
by the
largest investment and commercial banks, 168 depository institutions
failed
from 2007 through 2009.This was not the
largest number of bank failure in one crisis. At the height of the
savings and
loan (S&L) crisis from 1987 to 1993, 1,858 banks and thrifts
failed.
However, the dollar value of failed banks assets in the financial
crisis in
2007-2009 was $540 billion, roughly 1.5 times of the bank assets that
failed in
the S&L crisis in 1987-1993.
A research paper funded by the Federal Deposit Insurance
Corporation (FDIC) on Bank Failures and
the Cost of Systemic Risk: Evidence from 1900-1930, by Paul Kupiec
and Carlos
Ramireza (July 2008) found that bank failures reduce subsequent
economic
growth. Over this period, a 0.12 percent (1 standard deviation)
increase in the
liabilities of the failed depository institutions results in a
reduction of 17
percentage points in the growth rate of industrial production and a 4
percentage
point decline in real Gross National Product (GNP) growth. The
reductions occur
within three quarters of the initial bank failure shock and can be
interpreted
as a measure of the costs of systemic risk in the banking sector. The
FDIC had
been created by the New Deal only after 1934 to protect depositors.
In the current crisis that began in mid-2007, with the
discount rate falling steadily to 0.5% on December 16, 2008 from a high
of
6.25% set on June 2006, still 25 banks failed in 2008 and were taken
over by
the FDIC while 140 banks failed in 2009 and 33 banks failed in just the
first
two months of 2010, putting the fee-financed FDIC in financial stress.
Yet the
Fed raised the discount rate to 0.75% on February 19, 2010. In contrast, in the five
years prior
to 2008, only 11 banks had failed from the debt bubble even when the
discount
rate stayed within a range from 2% to 6.25%. Volcker, the Fearless
Slayer of the Inflation Dragon
In the 1980s, to counter stagflation in the US
economy, the Fed under Paul Volcker, (August 6, 1979 – August
11,
1987), fearless slayer of the inflation dragon, kept discount rate in
the
double digit range from July
20, 1979
to August 27 1982,
peaking
at 14% on May 4, 1981.
From
August 1982 to its peak in August 1987, the Dow Jones Industrial
Average (DJIA)
grew from 776 to 2722. The rise in market indices for the 19 largest
markets in
the world averaged 296 percent during this period.
Volcker, as chairman of the Fed before Greenspan, caused a
“double-dip” recession in 1979-80 and 1981-82 to cure double-digit
inflation,
in the process bringing the unemployment rate into double digits for
the first
time since 1940. Volcker then piloted the economy through its slow long
recovery that ended with the 1987 crash. To his credit, Volcker did
manage to
bring unemployment below 5.5%, half a point lower than during the
1978-79 boom,
and the acknowledged structural unemployment rate of 6%.
Two months after Volcker left the Fed, to be succeeded by
Alan Greenspan, the high interest rate left by Volcker, inter alia, led
to Black Monday, October 19, 1987, when
stock markets around the world crashed mercilessly, beginning in Hong
Kong,
spreading west to Tokyo and Europe as markets opened across global time
zones,
hitting New York only after markets in other time zones had already
declined by
a significant margin. The DJIA dropped 22.61%, by 508 points, to
1738.74 on
Black Monday 1987. On October 11, 2007, the DJIA
hit a high of 14198.10. On March 2, 2009, it lost
almost 300 points, or 4.2%, to end at 6763.29, its lowest point since April 25, 1997.
By the end of October, 1987, stock markets in Hong Kong
had fallen 45.8%, Australia
41.8%, New Zealand
60%, Spain
31%,
the United Kingdom
26.4%, the United States
22.68%, and Canada
22.5%. Fundamental assumptions such as market fundamentalism, efficient
market
hypothesis and market equilibrium were challenged by events. Despite
that
dismal record in the 1980s, Volcker was appointed by President Obama
two
decades later as first Chair of the President's Economic Recovery
Advisory
Board on February 6, 2009.
The 1987 stock-market crash was unleashed by the sudden
collapse of the safety dam of portfolio insurance, a hedging strategy
made
possible by the new option pricing theory advanced by Nobel laureates
Robert C
Merton and Myron S Scholes. Institutional investors found it possible
to manage
risk better by protecting their portfolios from unexpected losses with
positions in stock-index futures. Any fall in stock prices could be
compensated
by selling futures bought when stock prices were higher.
This strategy, while operative for each individual portfolio, actually
caused
the entire market to collapse from the dynamics of automatic
herd-selling of
futures. Investors could afford to take greater risks in rising markets
because
portfolio insurance offered a disciplined way of avoiding risk in
declines,
albeit only individually. But the reduction in individual risk was
achieved by
an increase in systemic risk.
As some portfolio insurers sold and market prices fell
precipitously, the computer programs of other insurers then triggered
further
sales, causing further declines that in turn caused the first group of
insurers
to sell even more shares and so on, in a high-speed downward spiral.
This in
turn electronically generated other computer driven sell orders from
the same
sources, and the market experienced a computer-generated meltdown at
high speed. The Unlearned Lesson
of the 1987 Crash
The 1987 crash provided clear empirical evidence of the structural flaw
in
market fundamentalism, which is the belief that the optimum common
welfare is
only achievable through a market equilibrium created by the effect of
countless
individual decisions of all market participants each seeking to
maximize his
own private gain through the efficient market hypothesis, and that such
market
equilibrium should not be distorted by any collective measures in the
name of
the common good or systemic stability.
Aggregate individual decisions and actions in unorganized unison can
and often
do turn into systemic crises that are detrimental to the common good.
Unregulated free markets can quickly become failed markets. Markets do
not
simply grow naturally after a spring rain. Markets are artificial
constructs
designed collectively by key participants who agree to play by certain
rules.
All markets are planned with the aim of eliminating any characteristic
of being
free for all operations. Free market is as much a fantasy as free love.
In response to the 1987 crash, the US Federal Reserve under its newly
installed
chairman, Alan Greenspan, with merely nine weeks in the powerful
office,
immediately flooded the banking system with new reserves, by having the
Fed Open
Market Committee (FOMC) buy massive quantities of government securities
from
the repo market. He announced the day after the crash that the Fed
would “serve
as a source of liquidity to support the economic and financial system.”
Greenspan created $12 billion of new bank reserves by buying up
government
securities from the market, the proceeds from which would enter the
banking
system.
The $12 billion injection of "high-power money" in one day caused the
Fed funds rate to fall by 75 basis points and halted the financial
panic,
though it did not cure the financial problem, which caused the US
economy to plunge into a recession that persisted for five subsequent
years.
Worst of all, the monetarist cure for systemic collapse put the
financial world
in a pattern of crisis every decade: the 1987 crash, the 1997 Asian
financial
crisis and the financial crisis of 2007.
High-power money injected into the banking system enables banks to
create more
bank money through multiple credit-recycling, lending repeatedly the
same funds
minus the amount of required bank reserves at each turn. At a 10%
reserve
requirement, $12 billion of new high-power money could generate in
theory up to
$120 billion of new bank money in the form of recycled bank loans from
new
deposits by borrowers.
The Brady Commission investigation of the 1987 crash showed that on October 19, 1987, portfolio
insurance trades in S&P 500 Index futures and New York Exchange
stocks that
crashed the market amounted to only $6 billion by a few large traders,
out of a
market trading total of $42 billion. The Fed’s injection of $120
billion was
three times the market trading total and 20 times the trades executed
by
portfolio insurance.
Yet post-mortem analyses of the 1987 crash suggest that though
portfolio insurance
strategies were designed to be interest-rate-neutral, the declining Fed
funds
rate was actually causing financial firms that used these strategies
globally to
lose money from exchange-rate effects. The belated awareness of this
effect
caused many institutions that had not understood the full dynamics of
the
strategies to shut down their previously highly profitable bond
arbitrage
units. The Rise of Hedge
Funds
This move later led to the migratory birth of new,
stand-alone hedge funds such as Long Term Capital Management (LTCM),
which
continued to apply similar highly leveraged strategies for spectacular
trading
profit of more than 70% returns on equity that eventual led it to the
edge of insolvency
when Russia unexpectedly defaulted on its dollar bonds in the summer of
1998.
The Fed had to orchestrate a private-sector creditor bailout of LTCM to
limit
systemic damage to the financial markets. The net effect was to extend
the
liquidity bubble further – causing it to migrate from a distressed
sector to a healthy
sector.
The 1987 crash reflected a stock-market bubble burst the liquidity cure
for
which led to a property bubble that, when it also burst, in turn caused
the
savings-and-loan (S&L) crisis.
While the 1987 crash was technically induced by program
trading, the falling dollar was also a major factor. Although the
dollar had
started to decline in exchange value by late February, 1985 due to US
fiscal
deficit, that decline had yet to reduce the US trade deficit, causing
protectionist sentiment in the US to mount as the trade deficit swelled
to an
annual rate of $120 billion in the summer of 1985. The Issue of Exchange
Rates
In part to deflect protectionist legislation, US officials
arranged a meeting of G-5 officials at the Plaza Hotel in New York on
September
22, 1985 with the purpose of ratifying an initiative to bring about an
orderly
decline in the dollar, observing that “recent shifts in fundamental
economic
conditions among their countries, together with policy commitments for
the
future, have not been fully reflected in exchange markets,” and
concluded that
“further orderly appreciation of the main non-dollar currencies against
the
dollar is desirable,” and that the G5 members “stand ready to cooperate
more
closely to encourage this.” During the seven weeks following the Plaza
Accord,
G-5 authorities sold nearly $9 billion, of which the US
sold $3.3 billion for other currencies, while speculators profited by
shorting
the dollar.
The dollar had declined to seven-year lows in early 1987 amid signs of
weakness
in the US
economy while the US
trade deficit continued to grow. Demand was sustained not by income but
by
debt. Public statements by Reagan Administration officials were
interpreted in
exchange markets as indicating a lack of official concern about the
ramifications of further declines in the dollar.
On February 22, 1987,
officials of the G5 plus Canada
and Italy
met
at the Louvre in Paris to
announce
that the dollar had fallen enough. But despite heavy intervention
purchases of
dollars following the Louvre Accord, the dollar continued to decline,
particularly against the yen. Market participants perceived delays in
the
implementation of expansionary fiscal measures in Japan
expected after the Louvre Accord and talks of trade sanctions on some
Japanese
products heightened concern about tension in US-Japanese trade
relations.
Following the Louvre Accord, the G-7 authorities intervened heavily in
support
of the dollar throughout the episodes of dollar weakness in 1987, and
sold
dollars on several occasions when the dollar strengthened
significantly. Net
official dollar purchases by the G-7 and other major central banks
effectively
financed more than two-thirds of the $144 billion US current account
deficit in
1987. The US
share of these purchases was $8.5 billion, and the share of the other
G-7
countries was $82 billion, since the non-dollar export-dependent
governments
wanted desperately to halt the appreciation of their currencies.
Record US trade deficits and market perceptions that the G-7
authorities were
pursuing monetary measures best suited to their own separate domestic
economic
objectives soon sparked a further sell-off of the dollar. This
contributed to a
worldwide collapse of equity prices which had risen to levels
unsupported by
fundamentals. The dollar’s decline gathered new momentum when the
Federal
Reserve under its new chairman Alan Greenspan moved more aggressively
than its
foreign counterparts to supply liquidity in the aftermath of the 1987
stock
market crash which had been triggered by program trading on portfolio
insurance
derivatives arbitraging on macroeconomic instability in exchange rates
and
interest rates. Domestic
Accommodative Monetary Stance and Exchange Rates
The Federal Reserve’s actions under Greenspan in 1987 led
market participants to conclude that the Fed would emphasize domestic
market objectives
with accommodative monetary stance, if necessary at the cost of a
further
decline in the dollar. By year-end, the dollar's value had fallen 21%
against
the yen and 14% against the mark from its levels at the time of the
Louvre
Accord while Greenspan, the wizard of bubble-land, was on his way to
being
hailed as the greatest central banker in history. Two decades later, by
2007,
the Greenspan put was called by the market and trillions of dollars
were lost. The Issue of Unemployment
Half a century before 1987, beginning in 1921, deflation had
descended on the US
economy like a perfect storm from Fed tight monetary policy under
Chairman
Daniel R. Grissinger, with farm commodity prices falling 50% from their
1920
peak, throwing farmers into mass bankruptcies. Business activity fell
by
one-third; manufacturing output fell by 42%; unemployment rose fivefold
to 11.9%,
adding 4 million to the jobless count.
Since mid-2007, the US
has lost over 6 million jobs, with 4.4 million jobs lost in the first
year of
the Obama administration. Latest government estimate puts the Great
Recession
of 2008 as having lost 8.4 million jobs thus far and no more than 1.4
million
jobs are expected to be restored by the end of 2010. Unemployment is
expected
to stay near double digit for the foreseeable future. If workers who
have given
up looking for work are also counted, the unemployment rate is close to
14% in
2010.
Some are attempting to put a positive spin on US
jobs numbers for February 2010 when the unemployment rate, though still
at
9.7%, held steady. The economy shed 36,000 jobs in January, but the
good news
was that the pace of job loss was moderating. An average of 27,000 jobs
was
lost each month since November 2009, compared with 727,000 jobs a month
on
average over the same period in 2008. When the laws of gravity says
what goes
up must eventually come down, there is no law that say what goes down
will
eventually come back up. That is how swimmers get drown; they float
back up
only after life has long left the body. Only dead bodies float
naturally.
While the unemployment rate is rising more slowly, it seems
likely to remain high. And despite the recent policy insistence that
the top
three priorities are jobs, jobs and jobs, both Congress and the Obama
administration are not taking concrete steps to create them quickly
beyond the
usual lukewarm tax incentives.
By February 2010, 8.4 million jobs have been lost since the
financial crisis began in July 2007. The normal 2.7 million jobs needed
to
absorb new workers coming into the economy were never created, leaving
the
economy bereft of 11.1 million jobs. To fill that cumulative employment
gap
while keeping a growing work force fully employed would require more
than
400,000 new jobs a month for the next three years, considerably in
excess of
even the most optimistic projections under current job creation
policies and
programs. Further, healthcare reform, if it is expected to save cost,
will
inevitably include a reduction of jobs.
Five states reported new highs for joblessness in January
2010: California, at
12.5%; South Carolina,
12.6%; Florida,
11.9%; North Carolina,
11.1%; and Georgia,
10.4%. Michigan’s
unemployment rate is still the nation’s highest, at 14.3%, followed by Nevada
with 13% and Rhode Island
at 12.7%. South Carolina
and California
rounded out the top five.
Employers are unlikely to make new hires until they can
profitably restore their current part-time work force to full time. In
the
private sector, just restoring hours cut during the recession will
neutralize
the equivalent of 2.8 million new jobs.
Congress is taking its time debating an undersized jobs bill
that is not expected to create anywhere near the jobs that the economy
needs in
2010. The good news is that during the second half of 2010, the economy
will
get a temporary, one-time job boost from the taking of the census,
which will
hire about one million minimum wage temporary workers. The danger is
that misleading
job statistics will allow both the Administration and Congress to avoid
meaningful job creation commitments needed for a genuine recovery.
Going
forward, a jobless recovery has become a given when the recovery finaly
comes. Public Sector Layoffs
The next unemployment trouble will come from the public
sector. Without timely and adequate Federal aid, the states and local
governments will be forced by falling tax revenue to tighten fiscal
budgets,
which will mean layoffs and cancelled private contracts, both of which
would
squeeze demand in the private sector to further reduce local government
revenue
in a downward spiral. The Fed’s
Deflationary Bias
Back in 1921, when the economy came to a screeching halt,
the Fed’s monetary ideological perspective was that declining prices
were the
goal, not the problem; unemployment was necessary to restore US
industry to a sound financial footing, freeing it from wage-pushed
inflation.
Potent medicine always came with a bitter taste, the central bankers
explained.
The bitterness was assigned to the worker, while the sweet success was
kept for
capital.
The Dominance of the New York Fed and
Internationalism
In 1913, farmers supported the establishment of a central because they
had hope
a central bank would not be controlled by moneyed interests in the
Northeast.
But their hope was dashed in 1921, when a technical process
inadvertently gave
the New York Federal Reserve Bank, which was closely allied with
internationalist banking interests, preeminent influence over the
Federal
Reserve Board in Washington,
the
composition of which had originally represented more balanced national
and
regional interests.
The initial operation of the Fed did not use the open-market
operation of buying or selling government securities as a method of
managing
the money supply. Money in the banking system was created entirely
through the
discount window at the regional Federal Reserve Banks. Instead of
buying or
selling government bonds, the regional Feds accepted “real bills” of
trade,
which when paid off would extinguish money in the banking system,
making the
money supply self-regulating in accordance with the “real bills”
doctrine of
money. The twelve regional Feds bought government securities not to
adjust
money supply, but to enhance their separate operating positive cash
flow by
parking idle funds in interest-bearing yet super-safe government
securities.
While the regional Feds did not need to make a profit, they felt a need
to
avoid incurring negative cash flow with the effect of inflating the
money
supply. They viewed their mandate as providing monetary support to
their
respective regional economies.
Bank economists at the time did not understand that when the regional
Feds
independently bought government securities, the aggregate effect would
result
in macro-economic implications of injecting “high power” money into the
banking
system, with which commercial banks could create more money in multiple
by
lending/depositing recycles through partial reserve banking
regulations.
When the Treasury sold bonds, the reverse would happen. When
the Fed made open market transactions, interest rates would rise or
fall
accordingly in financial markets. And when the regional Feds did not
act in
unison, the national credit market could become confused or become
disaggregated, as one regional Fed might buy while another might sell
government securities in its open market operations.
Benjamin Strong, the first president of the New York Federal Reserve
Bank, saw
the problem and persuaded the other 11 regional Feds to let the New
York Fed
handle all their transactions in a coordinated manner. The regional
Feds agreed
to form an Open Market Investment Committee for the purpose of
maximizing
overall profit for the whole system, being unaware that they were
signing away
their separate prerogative to support their respective regional
economies.
This new Committee was dominated by the New York Fed, which
was closely linked to big international money-center bank interests
which in
turn were closely tied to international financial markets in which the New
York banks were also key participants. The
Federal
Reserve Board approved the arrangement without full understanding of
its full
implication: that the Fed was falling under the undue influence of the New
York internationalist bankers who were more
interested in the value of the currency than the health of the economy,
particularly the regional economies. This fatal flaw would reveal
itself in the
Fed’s role in causing and its impotence in dealing with the 1929 crash
and all
subsequent market crashes.
While the Fed was careful not to expand the money supply, money was
created by
the rising use of margin in the stock market. The deep 1920-21
depression
eventually recovered into the margin-fed speculative Roaring Twenties,
which, in
many ways similar to the New Economy debt bubbles of the 1990s and
2000s, left
some segments of economy and the population in them lingering in a
depressed
state amid general prosperity. Farmers remained victimized by depressed
commodity
prices and factory workers shared in the prosperity only by working
longer
hours and assuming debt with the easy money that the banks provided.
Unions
lost 30% of their membership because of high unemployment. The
prosperity was
entirely fueled by the wealth effect of a speculative boom in the stock
market
that by the end of the decade would face the 1929 crash and land the
nation and
the world in the Great Depression.
Historical record showed that when New York Fed president Benjamin
Strong leaned on the other eleven regional Feds to ease the discount
rate on an
already overheated economy in 1927, the Fed lost its last window of
opportunity
to prevent the 1929 crash. Some historians claimed that Strong did so
to
fulfill his internationalist vision at the risk of endangering the
national
interest. The Dangerous Influence
of Milton Friedman
Milton Friedman, in his widely praised study of the monetary
causes of the Great Depression, focus on the role of the Fed by
claiming a
counterfactual insight that had the Fed responded to the 1929 crash
with
massive monetary easing, the Depression would have been avoided. In the
decades
from 1978 to 2007, Greenspan and Bernanke, both faithful Friedmanesque
doctrinaires, relied on the Friedman monetary cure to postpone the
inevitable
day of reckoning of debt-fueled speculation, in a market where on top
of Fed
easing of the money supply, money was being created without limits by
the use
of high leverage by financial manipulators. Hedge funds and investment
banks were
routinely using leverage at 40 to1 (bypassing the regulatory limit of
12 to 1)
as an industry standard for structured finance to make bet on minute
market
movements to produce unsustainably high returns that posed dangerous
systemic
risk to globalized financial markets.
When money is not backed by gold, its exchange value must be managed by
government, more specifically by the monetary policies of the central
banks.
Yet central bankers in the 1920s tended to be attracted to the gold
standard
because it can relieve them of the unpleasant and thankless
responsibility of
unpopular monetary policies to sustain the value of money. Central
bankers have
been caricatured as party spoilers who take away the punch bowl just
when the
party gets going.
Yet even a gold standard is based on a fixed value of money to gold,
set to
reflect the underlying economical conditions at the time of its
setting.
Therein rests the inescapable need for human judgment. Instead of
focusing on
the appropriateness of the level of money valuation under changing
economic
conditions, central banks often become fixated on merely maintaining a
previously set exchange rate between money and gold, doing serious
damage in
the process to any economy out of sync with that fixed rate. Economies
that do
not produce or possess a flexible supply of gold will be penalized by
the
inability to vary their money supply to meet the needs of their
economies.Central bankers do not
understand that the problem
is the currency’s fixed rate to gold and not the varying monetary needs
of a
dynamic economy.
When the exchange value of a currency falls, central bankers
often feel a personal sense of failure, while they merely shrug their
shoulders
to refer to natural laws of finance when the economy collapses from an
overvalued currency.
But the effectiveness of central bank intervention in the
money markets is steadily reduced by the ability of market participants
to
create money through the extending of credit. The sub-prime mortgage
syndrome
was essentially a private sector money printing press over which the
Fed had no
control since it ideologically placed faith in the unregulated market’s
inherent ability to self correct. While this faith has now been fully
discredited, regulatory reform is still stuck the political quicksand
of
special interest lobbying. More than two years after the outbreak of
the global
financial crisis, the financial markets are essentially still operating
under
the same regulations that brought them to a near meltdown. April 25,
2010
Next: Global
Sovereign Debt Crises
