The Federal Reserve, Roaring Twenties, Stock Market Crash, Banking Crises, Great Depression and John Maynard Keynes

Posted by PITHOCRATES - September 25th, 2012

History 101

The Federal Reserve increased the Money Supply to Lower Interest Rates during the Roaring Twenties

Benjamin Franklin said, “Industry, perseverance, & frugality, make fortune yield.”  He said that because he believed that.  And he proved the validity of his maxim with a personal example.  His life.  He worked hard.  He never gave up.  And he was what some would say cheap.  He saved his money and spent it sparingly.  Because of these personally held beliefs Franklin was a successful businessman.  So successful that he became wealthy enough to retire and start a second life.  Renowned scientist.  Who gave us things like the Franklin stove and the lightning rod.  Then he entered his third life.  Statesman.  And America’s greatest diplomat.  He was the only Founder who signed the Declaration of Independence, Treaty of Amity and Commerce with France (bringing the French in on the American side during the Revolutionary War), Treaty of Paris (ending the Revolutionary War very favorably to the U.S.) and the U.S. Constitution.  Making the United States not only a possibility but a reality.  Three extraordinary lives lived by one extraordinary man.

Franklin was such a great success because of industry, perseverance and frugality.  A philosophy the Founding Fathers all shared.  A philosophy that had guided the United States for about 150 years until the Great Depression.  When FDR changed America.  By building on the work of Woodrow Wilson.  Men who expanded the role of the federal government.  Prior to this change America was well on its way to becoming the world’s number one economy.   By following Franklin-like policies.  Such as the virtue of thrift.  Favoring long-term savings over short-term consumption.  Free trade.  Balanced budgets.  Laissez-faire capitalism.  And the gold standard.  Which provided sound money.  And an international system of trade.  Until the Federal Reserve came along.

The Federal Reserve (the Fed) is America’s central bank.  In response to some financial crises Congress passed the Federal Reserve Act (1913) to make financial crises a thing of the past.  The Fed would end bank panics, bank runs and bank failures.  By being the lender of last resort.  While also tweaking monetary policy to maintain full employment and stable prices.  By increasing and decreasing the money supply.  Which, in turn, lowers and raises interest rates.  But most of the time the Fed increased the money supply to lower interest rates to encourage people and businesses to borrow money.  To buy things.  And to expand businesses and hire people.  Maintaining that full employment.  Which they did during the Roaring Twenties.  For awhile.

The Roaring Twenties would have gone on if Herbert Hoover had continued the Harding/Mellon/Coolidge Policies

The Great Depression started with the Stock Market Crash of 1929.  And to this date people still argue over the causes of the Great Depression.  Some blame capitalism.  These people are, of course, wrong.  Others blamed the expansionary policies of the Fed.  They are partially correct.  For artificially low interest rates during the Twenties would eventually have to be corrected with a recession.  But the recession did not have to turn into a depression.  The Great Depression and the banking crises are all the fault of the government.  Bad monetary and fiscal policies followed by bad governmental actions threw an economy in recession into depression.

A lot of people talk about stock market speculation in the Twenties running up stock prices.  Normally something that happens with cheap credit as people borrow and invest in speculative ventures.  Like the dot-com companies in the Nineties.  Where people poured money into these companies that never produced a product or a dime of revenue.  And when that investment capital ran out these companies went belly up causing the severe recession in the early 2000s.  That’s speculation on a grand scale.  This is not what happened during the Twenties.  When the world was changing.  And electrifying.  The United States was modernizing.  Electric utilities, electric motors, electric appliances, telephones, airplanes, radio, movies, etc.  So, yes, there were inflationary monetary policies in place.  But their effects were mitigated by this real economic activity.  And something else.

President Warren Harding nominated Andrew Mellon to be his treasury secretary.  Probably the second smartest person to ever hold that post.  The first being our first.  Alexander Hamilton.  Harding and Mellon were laissez-faire capitalists.  They cut tax rates and regulations.  Their administration was a government-hands-off administration.  And the economy responded with some of the greatest economic growth ever.  This is why they called the 1920s the Roaring Twenties.  Yes, there were inflationary monetary policies.  But the economic growth was so great that when you subtracted the inflationary damage from it there was still great economic growth.  The Roaring Twenties could have gone on indefinitely if Herbert Hoover had continued the Harding and Mellon policies (continued by Calvin Coolidge after Harding’s death).  There was even a rural electrification program under FDR’s New Deal.  But Herbert Hoover was a progressive.  Having far more in common with the Democrat Woodrow Wilson than Harding or Coolidge.  Even though Harding, Coolidge and Hoover were all Republicans.

Activist Intervention into Market Forces turned a Recession into the Great Depression

One of the things that happened in the Twenties was a huge jump in farming mechanization.  The tractor allowed fewer people to farm more land.  Producing a boom in agriculture.  Good for the people.  Because it brought the price of food down.  But bad for the farmers.  Especially those heavily in debt from mechanizing their farms.  And it was the farmers that Hoover wanted to help.  With an especially bad policy of introducing parity between farm goods and industrial goods.  And introduced policies to raise the cost of farm goods.  Which didn’t help.  Many farmers were unable to service their loans with the fall in prices.  When farmers began to default en masse banks in farming communities failed.  And the contagion spread to the city banks.  Setting the stage for a nation-wide banking crisis.  And the Great Depression.

One of the leading economists of the time was John Maynard Keynes.  He even came to the White House during the Great Depression to advise FDR.  Keynes rejected the Franklin/Harding/Mellon/Coolidge policies.  And the policies favored by the Austrian school of economics (the only people, by the way, who actually predicted the Great Depression).  Which were similar to the Franklin/Harding/Mellon/Coolidge policies.  The Austrians also said to let prices and wages fall.  To undo all of that inflationary damage.  Which would help cause a return to full employment.  Keynes disagreed.  For he didn’t believe in the virtue of thrift.  He wanted to abandon the gold standard completely and replace it with fiat money.  That they could expand more freely.  And he believed in demand-side solutions.  Meaning to end the Great Depression you needed higher wages not lower wages so workers had more money to spend.  And to have higher wages you needed higher prices.  So the employers could pay their workers these higher wages.  And he also encouraged continued deficit spending.  No matter the long-term costs.

Well, the Keynesians got their way.  And it was they who gave us the Great Depression.  For they influenced government policy.  The stock market crashed in part due to the Smoot Hawley Tariff then in committee.  But investors saw the tariffs coming and knew what that would mean.  An end to the economic boom.  So they sold their stocks before it became law.  Causing the Stock Market Crash of 1929.  Then those tariffs hit (an increase of some 50%).  Then they doubled income tax rates.  And Hoover even demanded that business leaders NOT cut wages.  All of this activist intervention into market forces just sucked the wind out of the economy.  Turning a recession into the Great Depression.

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Federal Reserve System, Great Depression, Banking Crises, Gold Reserves, Gold Exchange Standard, Interest Rates and Money Supply

Posted by PITHOCRATES - July 31st, 2012

History 101

The Gold Exchange Standard provided Stability for International Trade

Congress created the Federal Reserve System (the Fed) with the passage of the Federal Reserve Act in 1913.  They created the Fed because of some recent bad depressions and financial panics.  Which they were going to make a thing of the past with the Fed.  It had three basic responsibilities.  Maximize employment.  Stabilize prices.  And optimize interest rates.  With the government managing these things depressions and financial panics weren’t going to happen on the Fed’s watch.

The worst depression and financial panic of all time happened on the Fed’s watch.  The Great Depression.  From 1930.  Until World War II.  A lost decade.  A period that saw the worst banking crises.  And the greatest monetary contraction in U.S. history.  And this after passing the Federal Reserve Act to prevent any such things from happening.  So why did this happen?  Why did a normal recession turn into the Great Depression?  Because of government intervention into the economy.  Such as the Smoot-Hawley Tariff Act that triggered the great selloff and stock market crash.  And some really poor monetary policy.  As well as bad fiscal policy.

At the time the U.S. was on a gold exchange standard.  Paper currency backed by gold.  And exchangeable for gold.  The amount of currency in circulation depended upon the amount of gold on deposit.  The Federal Reserve Act required a gold reserve for notes in circulation similar to fractional reserve banking.  Only instead of keeping paper bills in your vault you had to keep gold.  Which provided stability for international trade.  But left the domestic money supply, and interest rates, at the whim of the economy.  For the only way to lower interest rates to encourage borrowing was to increase the amount of gold on deposit.  For with more gold on hand you can increase the money supply.  Which lowered interest rates.  That encouraged people to borrow money to expand their businesses and buy things.  Thus creating economic activity.  At least in theory.

The Fed contracted the Money Supply even while there was a Positive Gold Flow into the Country

The gold standard worked well for a century or so.  Especially in the era of free trade.  Because it moved trade deficits and trade surpluses towards zero.  Giving no nation a long-term advantage in trade.  Consider two trading partners.  One has increasing exports.  The other increasing imports.  Why?  Because the exporter has lower prices than the importer.  As goods flow to the importer gold flows to the exporter to pay for those exports.  The expansion of the local money supply inflates the local currency and raises prices in the exporter country.  Back in the importer country the money supply contracts and lowers prices.  So people start buying more from the once importing nation.  Thus reversing the flow of goods and gold.  These flows reverse over and over keeping the trade deficit (or surplus) trending towards zero.  Automatically.  With no outside intervention required.

Banknotes in circulation, though, required outside intervention.  Because gold isn’t in circulation.  So central bankers have to follow some rules to make this function as a gold standard.  As gold flows into their country (from having a trade surplus) they have to expand their money supply by putting more bills into circulation.  To do what gold did automatically.  Increase prices.  By maintaining the reserve requirement (by increasing the money supply by the amount the gold deposits increased) they also maintain the fixed exchange rate.  An inflow of gold inflates your currency and an outflow of gold deflates your currency.  When central banks maintain this mechanism with their monetary policy currencies remain relatively constant in value.  Giving no price advantage to any one nation.  Thus keeping trade fair.

After the stock market crash in 1929 and the failure of the Bank of the United States in New York failed in 1930 the great monetary contraction began.  As more banks failed the money they created via fractional reserve banking disappeared.  And the money supply shrank.  And what did the Fed do?  Increased interest rates.  Making it harder than ever to borrow money.  And harder than ever for banks to stay in business as businesses couldn’t refinance their loans and defaulted.  The Fed did this because it was their professional opinion that sufficient credit was available and that adding liquidity then would only make it harder to do when the markets really needed additional credit.  So they contracted the money supply.  Even while there was a positive gold flow into the country.

The Gold Standard works Great when all of your Trading Partners use it and they Follow the Rules

Those in the New York Federal Reserve Bank wanted to increase the money supply.  The Federal Reserve Board in Washington disagreed.  Saying again that sufficient credit was available in the market.  Meanwhile people lost faith in the banking system.  Rushed to get their money out of their bank before it, too, failed.  Causing bank runs.  And more bank failures.  With these banks went the money they created via fractional reserve banking.  Further deflating the money supply.  And lowering prices.  Which was the wrong thing to happen with a rising gold supply.

Well, that didn’t last.  France went on the gold standard with a devalued franc.  So they, too, began to accumulate gold.  For they wanted to become a great banking center like London and New York.  But these gold flows weren’t operating per the rules of a gold exchange.  Gold was flowing generally in one direction.  To those countries hoarding gold.  And countries that were accumulating gold weren’t inflating their money supplies to reverse these flows.  So nations began to abandon the gold exchange standard.  Britain first.  Then every other nation but the U.S.

Now the gold standard works great.  But only when all of your trading partners are using it.  And they follow the rules.  Even during the great contraction of the money supply the Fed raised interest rates to support the gold exchange.  Which by then was a lost cause.  But they tried to make the dollar strong and appealing to hold.  So people would hold dollars instead of their gold.  This just further damaged the U.S. economy, though.  And further weakened the banking system.  While only accelerating the outflow of gold.  As nations feared the U.S. would devalue their currency they rushed to exchange their dollars for gold.  And did so until FDR abandoned the gold exchange standard, too, in 1933.  But it didn’t end the Great Depression.  Which had about another decade to go.

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