The Great Deformation
by David A. Stockman, published 2013
Stockman doesn’t go into much detail on where the boom ending in 1929 came from, but he does provide an interpretation of why the bust lasted so long and went so deep– the forcible closing off of international trade via protectionist policies and the undermining of the global gold-backed monetary regime by American and European governments alike.
In Stockman’s telling, American president Herbert Hoover was a mostly free enterprise and sound money kind of guy who wanted to avoid inflationist solutions to the economic slump. By 1932 the economy had liquidated the bulk of the malinvestments in excess inventories and capital assets and was ready to turn toward genuine recovery. This process only took as long as it did because ill-reasoned policies like the Smoot-Hawley Act in the United States and similar nationalistic policies in European states along with uncertainty about the British plans to keep the gold-backed pound sterling in place hampered international trade flows. According to Stockman, the United States between 1914 and 1929 had become, much like China circa 1994-2012, a major exporter of capital and consumer goods to the rest of the world particularly in response to trade and economic disruptions of industry and agriculture in European economies during the First World War. The US economy was geared up to provide steel, cotton, cereal grains and other commodities to the rest of the world and had a hard time adjusting output to meet domestic demand when the collapse came in 1929.
Then came FDR and his unique brand of economically inane autarkic nationalist policy. Stockman faults FDR for prolonging, nay, creating, the actual Depression singlehandedly. First, FDR began his presidency by fomenting a banking crisis and declaring a major bank holiday which Stockman saw as unnecessary. As Stockman tells it, the 12,000 some bank failures in the United States during this period mostly occurred in over leveraged regional/rural banks centered around the agricultural and export-oriented areas of the economy representing at most 3% of banking system deposits. Major money center banks in financial centers such as New York never faced a solvency crisis, making FDRs response a solution to a nonexistent problem and therefore a serious problem-creating blunder itself.
Second, FDR torpedoed the London Conference on international monetary mechanisms, throwing the whole system into chaos and instigating another round of protectionist measures at home and abroad. Third, he arbitrarily decided to undermine the US’s own commitment to a constant redeemability ratio for the dollar, creating further fear and uncertainty in the economy. And finally, he created a cartel system (National Recovery Administration) which served to freeze prices, arbitrarily shift capital around the economy and buy votes as necessary but did nothing to create the kind of stable conditions preferred by business people and entrepreneurs attempting to make capital investments to serve anticipated consumer demand.
The Depression was a recession that was working itself out despite the protectionist political measures put in place which made adjusting the structure of production to domestic rather than foreign needs, but then FDR came along and made the economy his plaything as he tinkered according to his whims and played power broker on the side. That’s what turned the recession into a true Depression.
Fannie Mae, which was envisioned as a way to revitalize a moribund middle class housing market during the Great Depression by creating a “secondary market” for uneconomic 30 year mortgages at subsidized interest rates, has in the 75 years since its founding led to the total corruption and now nationalization of the home loan market. The creation of the secondary market divorced mortgage underwriting from mortgage servicing as it allowed for mortgages to be easily issued, packaged up and sold to investors as government-backstopped financial products. Further, it resulted in local savings funding local housing investments being transformed into a national and now international market, with the final result being that “Red China” bankrolls $1T+ of the federal home loan market due to balance of payment issues tied to competitive currency issuance.
Social Security, rather than being the crowning social achievement of the New Deal, was its greatest fiscal folly and has created an embarrassing Ponzi legacy that is with us even today. The systems actuarial projections were based on an impossible 5% continual GDP growth rate. The payroll tax used to fund it has proved “regressive” and continues to grow over time, with a current 6.5% of GDP consumed by the tax. The $3T of “trust fund reserves” have been lent out and spent by other parts of the government and represent nothing more than future taxes due.
In so many words, the innovation of deposit insurance combined with the Glass-Steagall act, a bout of inflationary monetary policy which destroyed the profitability of traditional deposit lending under Glass-Steagall and then a round of “deregulations” designed to create new areas of profitability for banks at the expense of growing moral hazard resulted in the utter corruption of the system and the inevitability of a major financial meltdown as witnessed in 2008.
With the outbreak of war in Europe in 1914 and the initiation of a war loan program by the United States government, US farms became the breadbasket of the world. They took on massive debt to expand capital machinery and bring additional acreage into cultivation which resulted in growing farm output prices. When the war ended, the capital investments, including the debt overhang, remained. The financial collapse in the 1930s further exacerbated the situation, leaving farmers as a desperate coalition looking for a political solution to their contractual obligations.
With the nations farmers the hardest hit by the twin spikes of failing cash flow and high debt burdens, they became a powerful voting bloc that got FDR elected which allowed for the cartelization of the farming industry to take place. The thought was that cartelizing the industry and pushing up farm and farm output prices would result in a return to prosperity as rural buyers bought manufactured products from city centers. With their programs in place, the farming lobby was then willing to trade votes for growth and maintenance of these subsidies and controls going forward into the future.
The “Thomas Amendment” created four options for expanding the money supply via currency issuance or gold or silver content debauchery. This inflationary response was seen as the proper antidote to too much debt and too little money and political authorities of the day figured it would give them a free pass to avoid the pains of the bust following the ill-gotten gains of the boom.
FDR channeled the $2.8B windfall from his emergency dollar “revaluation” against gold into his Exchange Stabilization Fund, which the Secretary of the Treasury was then able to disburse at his discretion, turning him into what Stockman calls a “money czar” much like Hank Paulson and Neil Kashkari during TARP.
In this chapter, Stockman argues that World War II and the Korean War were the last wars to be mostly financed by current taxation in the US. WWII in particular saw a rise in household saving and a decline in household indebtedness that offset the massive rise in public indebtedness. He attributes this in part to the fact that wartime command economy measures dictated that there was little to consume on store shelves, in part to the fact that the government’s propaganda campaigns for war bond drives were a success and in part because the government had adopted an arbitrary bond yield peg that lowered investment returns in competing assets and made government bonds more attractive as a conservative savings vehicle.
Stockman claims that William McChesney Martin, who headed the Fed through the 1950s, was a “tribune of sound money” and saw it as his mission to restrain credit expansion and tame the inflation rate, rather than to stoke it like modern Fed heads. He also claims that the Fed only lent on liquid commercial receivables during this era, compared with the present where the Fed has become a warehouse for illiquid claims on real assets.
Stockman argues that President Eisenhower was the “last of the fiscal Mohicans” dedicated to trimming federal budgets and making government spending respectful of tax revenue means. At the same time, a growing chorus of voices on the right and the left begin arguing for a “new economics”, Keynesian government planning of the macro economy, to not only fight recessions but “fine tune potential GDP” during recoveries and booms. This theory comes at the expense of sound money and has a pro-inflation bias.
Following World War I, Great Britain attempted to return to the pre-war parity between the pound Sterling, gold and the US dollar despite a massive inflation during the war years. At the same time, the British government embarked on an expansion of its domestic welfare programs which ultimately broke the back of the pound culminating in the London gold conference in 1931 which proved the futility of maintaining the old exchange ratios in the face of inflationary chaos.
At the end of World War II, the United States attempted to take the lead with a gold-backed dollar as the world’s reserve currency in a new arrangement, the gold exchange standard, engineered at the Bretton Woods conference in 1944. Of course, the architect of this scheme was the exact same architect of the doomed British plan (monetary and social policy), the imperious Lord Keynes. And rather than a true gold standard, what Keynes wrought was a feeble attempt to hide dollar inflation by creating a scheme where foreign exchange was to be exchanged for dollars, not gold, which was ostensibly suppose to allow additional credit and currency to be pyramided atop the same amount of gold reserves at formal exchange rates.
For a time, this precarious system seemed to work, helped along by the US-led international “gold pool” which sought to exchange gold against currency to calm price increases in the private London gold market.
However, the decision to engage in fiscal expansionism in the US via welfare spending increases and costly wars abroad (ie, Vietnam) all financed by deficit spending rather than real tax increases led to an unhinged inflation and a boiling London gold market. The international gold pool was quickly depleted in a series of panics in the late 1960s, eventually culminating in Nixon’s infamous closing of the US gold window.
This “guns and butter” policy, led by the intellectual disciples of Keynes ensconced in major US universities, was the final nail in the coffin of sound money in the US, and perhaps even the world, and ushered in a new era of freely floating currencies, chronic deficits, massive credit expansion and a seemingly never-ending series of financial and economic bubbles that we are all living with the consequences of today– ironically, the media at the time was fooled into believing this “enlightened” policy had permanently tamed the (government-policy induced) business cycle.
Milton Friedman, hailed as a staunch libertarian and champion of small government politics and free market economics, gave intellectual blessing to the greatest economic bastardization of all time– the transformation of the gold standard US dollar, once and for all, into the “T-bill Standard”.
Friedman’s erroneous analysis of the cause of the Great Depression — a crashing M1 money supply caused by an overly tight Federal Reserve — led him to faith in a new standard for monetary policy, a simple inflation targeting of 3% per annum, with the market smoothing out the rest. Friedman believed that if the Fed could credibly adhere to a uniform rate of inflation over time, the business cycle could be banished and the economy would be free to grow without abatement and without the restrictive context of a gold-backed currency.
This new policy proved its danger almost immediately with the out of control inflation of the 1970s and opened the door for unending deficit finance by the federal government. And while Friedman had hoped for a series of Fed chairmen who would objectively guide the M1 money supply along this path (a strategy destined to failure because it turns out the Fed doesn’t control M1, market demand for loanable funds does) instead the office has been inhabited by activist acolytes since the tight money days of Volcker.
The current global monetary regime of competitive free floating currencies is truly without precedent and much of the modern US’s largesse was financed by willing mercantilist politicians in foreign trading partner nations. It remains to be seen what happens to this system when one or more countries reach the end of their rope, domestically, and are not longer willing to import the United States’ inflation as they export their wealth to foreigners for consumption.