Panic of 1907, Federal Reserve Act and Depression of 1920

Posted by PITHOCRATES - December 17th, 2013

History 101

In 1907 the Heinze Brothers thought Investors were Shorting the Stock of their United Copper Company

Buying and selling stocks is one way to get rich.  Typically by buying low and selling high.  But you can also get rich if the stock price falls.  How you ask?  By short-selling the stock.  You borrow shares of a stock that you think will fall in price.  You sell them at the current price.  Then when the stock price falls you buy the same number of shares you borrowed at the lower price.  And use these to return the shares you borrowed.  You subtract the price you pay to buy the cheaper shares from the proceeds of selling the costlier shares for your profit.  And if the price difference/number of shares is great enough you can get rich.

In 1907 the Heinze brothers thought investors were shorting the stock of their United Copper Company.  So they tried to turn the tables on them and get rich.  They already owned a lot of the stock.  They then went on a buying spree with the intention of raising the price of the stock.  If they successfully cornered the market on United Copper Company stock then the investors shorting the stock would have no choice but to buy from them to repay their borrowed shares.  Causing the short sellers to incur a great loss.  While reaping a huge profit for themselves.

Well, that was the plan.  But it didn’t quite go as planned.  For they did not control as much of the stock as they thought they did.  So when the short-sellers had to buy new shares to replace their borrowed shares they could buy them elsewhere.  And did.  When other investors saw they weren’t going to get rich on the cornering scheme the price of the stock plummeted.  For the stock was only worth that inflated price if the short-sellers had to buy it at the price the Heinze brothers dictated.  When the cornering scheme failed the stock they paid so much to corner was worth nowhere near what they paid for it.  And they took a huge financial loss.  But it got worse.

The Panic of 1907 led to the Federal Reserve Act of 1913

After getting rich in the copper business in Montana they moved east to New York City.  And entered the world of high finance.  And owned part of 6 national banks, 10 state banks, 5 trusts (kind of like a bank) and 4 insurance companies.  When the cornering scheme failed the Heinze brothers lost a lot of money.  Which spooked people with money in their banks and trusts.  As these helped finance their scheme.  So the people rushed to their banks and pulled their money out.  Causing a panic.  First their banks.  Then their trusts.  Including the Knickerbocker Trust Company.  Which collapsed.  As the contagion spread to other banks the banking system was in risk of collapsing.  Causing a stock market crash.  Resulting in the Panic of 1907.

Thankfully, a rich guy, J.P. Morgan, stepped in and saved the banking system.  By using his own money.  And getting other rich guys to use theirs.  To restore liquidity in the banking system.  To avoid another liquidity crisis like this Congress passed the Federal Reserve Act (1913).  Giving America a central bank.  And the progressives the tool to take over the American economy.  Monetary policy.  By tinkering with interest rates.  And breaking away from the classical economic policies of the past that made America the number one economic power in the world.  Built on a foundation of thrift, savings, investment, free trade, the gold standard, etc.  Where people saved for the future.  The greater their savings the more investment capital there was.  And the lower interest rates were.

The Federal Reserve (the Fed) changed all of that.  By printing money to keep interest rates artificially low.  Giving us boom and bust cycles as people over invest and over build because of cheap credit.  Leading to bubbles (the boom) in asset prices that painful recessions (the bust) correct.  Instead of the genuine growth that we got when our savings determined interest rates.  Where there is no over-investing or over-building.  Because the limited investment capital did not permit it.  Guaranteeing the efficient flows of capital to generate real economic activity.

Warren Harding’s Tax Cuts ignited Economic Activity and gave us the Modern World

Thanks to the Fed there was a great monetary expansion to fund World War I.  The Fed cut the reserve requirements in half for banks.  Meaning they could loan more of their deposits.  And they did.  Thanks to fractional reserve banking these banks then furthered the monetary expansion.  And the Fed kept the discount rate low to let banks borrow even more money to lend.  The credit expansion was vast.  Creating a huge bubble in asset prices.  Creating a lot of bad investments.  Or malinvestments.  Economist Ludwig von Mises had a nice analogy to explain this.  Imagine a builder constructing a house only he doesn’t realize he doesn’t have enough materials to finish the job.  The longer it takes for the builder to realize this the more time and resources he will waste.  For it will be less costly to abandon the project before he starts than waiting until he’s built as much as he can only to discover he will be unable to sell the house.  And without selling the house the builder will be unable to recover any of his expenses.  Giving him a loss on his investment.

The bigger those bubbles get the farther those artificially high prices have to fall.  And they will fall sooner or later.  And fall they did in 1920.  Giving us the Depression of 1920.  And it was bad.  Unemployment rose to 12%.  And GDP fell by 17%.  Interestingly, though, this depression was not a great depression.  Why?  Because the progressives were out of power.  Instead of the usual Keynesian solution to a recession Warren Harding (and then Calvin Coolidge after Harding died in office) did the opposite.  There was no stimulus deficit-spending.  There was no playing with interest rates.  Instead, Harding cut government spending.  Nearly in half.  And he cut tax rates.  These actions led to a reduction of the national debt (that’s DEBT—not deficit) by one third.  And ignited economic activity.  Ushering in the modern world (automobiles, electric power, radio, telephone, aviation, motion pictures, etc.).  Building the modern world generated real economic activity.  Not a credit-driven bubble.  Giving us one of the greatest economic expansions of all time.  The Roaring Twenties.  Ending the Depression of 1920 in only 18 months.  Without any Fed action or Keynesian stimulus spending.

By contrast FDR used almost every Keynesian tool available to him to end the Great Depression.  But his massive New Deal spending simply failed to end it.  After a decade or so of trying.  Proving that government spending cannot spend an economy out of recession.  But cuts in government spending and cuts in tax rates can.  Which is why the Great Recession lingers on still.  Some 6 years after the collapse of one of the greatest housing bubbles ever.  Created by one of the greatest credit expansions ever.  For President Obama is a Keynesian.  And Keynesian policies only lead to boom-bust cycles.  Not real economic growth.  The kind we got from classical economic policies.  Built on a foundation of thrift, savings, investment, free trade, the gold standard, etc.  The economic policies that made America the number economic power in the world.

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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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LESSONS LEARNED #28: “Politicians love failure because no one ever asked government to fix something that was working.” -Old Pithy

Posted by PITHOCRATES - August 26th, 2010

THE TELEVISION SHOW Gomer Pyle, U.S.M.C. aired from 1964-1969.  It was a spinoff from the Andy Griffith Show.  Gomer, a naive country bumpkin who worked at Wally’s filling station, joined the Marines Corps.  And there was much mirth and merriment.  To the chagrin of Sergeant Carter, Pyle’s drill instructor (DI).  Think of Gunny Sergeant R. Lee Ermey’s Sergeant Hartman in the movie Full Metal Jacket only with no profanity or mature subject matter.  Sergeant Carter was a tough DI like Sergeant Hartman.  But more suitable for the family hour on prime time television.

Gunny sergeants are tough as nails.  And good leaders.  They take pride in this.  But sometimes a gunny starts to feel that he’s not himself anymore.  This was the subject of an episode.  And Gomer, seeing that Sergeant Carter was feeling down, wanted to help.  So he stuffed Sergeant Carter’s backpack with hay before a long march.  While the platoon was worn and tired, Sergeant Carter was not.  He was feeling good.  Like his old self.  Until he found out he was not carrying the same load his men were.  He asked Pyle, “why hay?”  He could understand rocks, but hay?  Because if he outlasted his men while carrying a heavier load, he would feel strong.  But knowing he had carried a lighter load only made him feel weak.

This is human nature.  People take pride in their achievements.  They don’t take pride in any achievement attained by an unfair advantage.  Self-esteem matters.  And you can’t feel good about yourself if you need help to do what others can do without help. 

AN OLD CHINESE proverb goes, “Give a man a fish and you feed him for a day. Teach a man to fish and you feed him for a lifetime.”  Let’s say I am a fisherman in a small village.  I catch fish to feed my family and sell/trade for other family needs.  There’s a man in my village who asks me for a fish each day so he can eat.  I’m a caring person.  So I give him a fish each day.  So a pattern develops.  Each day he shows up when I come in from my fishing.  He takes the fish and goes away.  It works out well for him.  He doesn’t have to work.  He can live off of my kind charity.  Then I move.  Without me being there to give him a fish each day, he no longer can eat.  And dies.  If I only had taught that man to fish. 

Kindness can lead to dependency.  And once dependent, you become lazy.  Why develop marketable skills to provide for yourself when someone else will provide for you?  The problem is, of course, what happens when that charity ends?  If you’re unable to provide for yourself and there is no longer someone providing for you, what do you do?  Steal?

Dependency and a lack of self-esteem are a dangerous combination.  And they feed off of each other.  This combination can lead to depression.  Behavioral problems.  Resentment.  Bitterness.  Envy.  Or a defeatist attitude.

These are often unintended consequences of government programs.  A failed program, then, has far reaching consequences beyond the initial economic costs of a program.

LIQUIDITY CRISES CAUSE a lot of economic damage.  If capital is not available for businesses to borrow, businesses can’t grow.  Or create jobs.  And we need jobs.  People have to work.  To support themselves.  And to pay taxes to fund the government.  So everyone is in favor of businesses growing to create jobs.  We all would like to see money being easy and cheap to borrow if it creates jobs.

But there is a downside to easy money.  Inflation.  Too much borrowing can create inflation.  By increasing the money supply (via fractional reserve banking).  More money means higher prices.  Because each additional dollar is worth a little less. This can lead to overvalued assets as prices are ‘bid’ up with less valuable dollars.  And higher prices can inflate business profits.  Looks good on paper.  But too much of this creates a bubble.  Because those high asset values and business profits are not real.  They’re inflated.  Like a bubble.  And just as fragile.  When bubbles burst, asset values and business profits drop.  To real values.  People are no longer ‘bidding’ up prices.  They stop buying until they think prices have sunk to their lowest.  We call this deflation.  A little bit of inflation or deflation is normal.  Too much can be painful economically.  Like in the Panic of 1907.

Without going into details, there was a speculative bubble that burst in 1907.  This led to a liquidity crisis as banks failed.  Defaults on loans left banks owing more money than they had (i.e., they became illiquid).  They tried to borrow money and recall loans to restore their liquidity.  Borrowers grew concerned that their bank may fail.  So they withdrew their money.  This compounded the banks problems.  This caused deflation.  Money was unavailable.  Causing bank runs.  And bank failures.  Business failures.  And unemployment grew. So government passed the Federal Reserve Act of 1913 to prevent a crisis like this from ever happening again.  The government gave the Federal Reserve System (the Fed) great powers to tweak the monetary system.  The smartest people at the time had figured out what had gone wrong in 1907.  And they created a system that made it impossible for it to happen again.

The worst liquidity crisis of all time happened from 1929-1933.  It’s part of what we call the Great Depression.  The 1920s had a booming economy.  Real income was rising.  Until the Fed took action.  Concerned that people were borrowing money for speculative purposes (in paper investments instead of labor, plant and material), they put on the brakes.  Made it harder and more expensive to borrow money.  Then a whole series of things happened along the way that turned a recession into a depression.  When people needed money, they made it harder to get it, causing a deflationary spiral.  The Great Depression was the result of bad decisions made by too few men with too much power.  It made a crisis far worse than the one in 1907.  And the Roosevelt administration made good use of this new crisis.  FDR exploded the size of government to respond to the unprecedented crisis they found themselves in.  The New Deal changed America from a nation of limited government to a country where Big Government reigns supreme.

ONE PROGRAM OF the New Deal was Social Security.  Unemployment in the 1930s ran at or above 14%.  This is for one whole decade.  Never before nor since has this happened.  Older workers generally earn more than younger ones.  Their experience commands a higher pay rate.  Which allows them to buy more things.  Resulting in more bills.  Therefore, the Great Depression hit older workers especially hard.  A decade of unemployment would have eaten through any life savings of even the most prudent savers.  And what does this get you?  A great crisis.

The government took a very atypical moment of history and changed the life of every American.  The government forced people to save for retirement.  In a very poor savings plan.  That paid poorly by comparison to private pensions or annuities.  And gave the government control over vast amounts of money.  It was a pervasive program.  They say FDR quipped, “Let them try to undo this.” 

With government taking care of you in retirement, more people stopped providing for themselves.  When they retired, they scrimped by on their ‘fixed’ incomes.  And because Social Security became law before widespread use of birth control and abortion, the actuaries of the day were very optimistic.  They used the birth rate then throughout their projections.  But with birth control and abortion came a huge baby bust.  The bottom fell out of the birth rate.  A baby bust generation followed a baby boom generation.  Actually, all succeeding generations were of the bust kind.  The trend is growing where fewer and fewer people pay for more and more people collecting benefits.  And these people were living longer.  To stay solvent, the system has to raise taxes on those working and reduce benefits on those who are not.  Or raise the retirement age.  All these factors have made it more difficult on our aged population.  Making them working longer than they planned.  Or by making that fixed income grow smaller.

FDR used a crisis to create Social Security.  Now our elderly people are dependent on that system.  It may suck when they compare it to private pensions or annuities, but it may be all they have.  If so, they’ll quake in their shoes anytime anyone mentions reforming Social Security.  Because of this it has become the 3rd rail of politics.  A politician does not touch it lest he or she wishes to die politically.  But it’s not all bad.  For the politician.  Because government forced the elderly to rely on them for their retirement, it has made the Social Security recipient dependent on government.  In particular, the party of government who favors Big Government.  The Democrats.  And with a declining birth rate and growing aged population, this has turned into a large and loyal voting bloc indeed.  Out of fear.

A PROGRAM THAT straddled the New Deal and LBJ’s Great Society was Aid to Families with Dependent Children (AFDC).  Its original New Deal purpose was to help widows take care of their children.  When program outlays peaked in the 1970s, the majority of recipients were unmarried women and divorced women.  Because this was a program based on need, the more need you had the more you got.  Hence more children meant more money.  It also reduced the importance of marriage as the government could replace the support typically provided by a husband/father.  Noted economist Dr. Thomas Sowell blames AFDC as greatly contributing to the breakdown of the black family (which has the highest incidence of single-parent households).

With the women’s liberation movement, women have come to depend less on men.  Some affluent women conceive and raise children without a husband.  Or they adopt.  And the affluent no doubt can provide all the material needs their children will ever need.  Without a husband.  Or a father for their children.  But is that enough?

The existence of ‘big brother’ programs would appear to prove otherwise.  Troubled children are often the products of broken families.  Mothers search for big brothers to mentor these fatherless sons.  To be role models.  To show an interest in these children’s lives.  To care.  When no such role models are available, some of these troubled children turn to other sources of acceptance and guidance.  Like gangs.

AFDC has compounded this problem by providing the environment that fosters fatherless children.  And another government program compounds that problem.  Public housing.

POOR HOUSING CONDITIONS hurt families.  They especially hurt broken families.  Without a working husband, these families are destined to live in the cheapest housing available.  These are often in the worst of neighborhoods.  This is an unfair advantage to the children raised in those families.  For it wasn’t their fault they were born into those conditions.  So, to solve that problem, government would build good public housing for these poorest of the poor to move into.  Problem solved.

Well, not exactly.  Public housing concentrates these broken families together.  Usually in large apartment buildings.  This, then, concentrates large numbers of troubled children together.  So, instead of having these children dispersed in a community, public housing gathers them together.  Where bad behavior reinforces bad behavior.  It becomes the rule, not the exception.  Making a mother’s job that much more difficult.  And because these children live together, they also go to school together.  And this extends the bad behavior problem to the school.  Is it any wonder that public housing (i.e., the projects) have the worst living conditions?  And some of the highest gang activity? 

Government didn’t plan it this way.  It’s just the unintended consequences of their actions.  And those consequences are devastating.  To the poor in general.  To the black family in particular.  AFDC and public housing enabled irresponsible/bad behavior.  That behavior destroyed families.  As well as a generation or two.  But it wasn’t all bad.  For the politicians.  It made a very large constituency dependent on government.

THERE ARE SO many more examples.  But the story is almost always the same.  Dependency and a lack of self-esteem will beat down a person’s will.  Like an addict, it will make the dependent accept poorer and poorer living standards in exchange for their fix of dependency.  Eventually, the dependency will reach the point where they will not know how to provide for themselves.  The dependency will become permanent.  As will the lack of self-esteem.  Conscious or not of their actions, Big Government benefits from the wretched state they give these constituencies.  With no choice but continued dependence, they vote for the party that promises to give the most.  Which is typically the Democrat Party.

But how can you fault these politicians?  They acted with the best of intentions.  And they can fix these new problems.  They’ll gather the brightest minds.  They’ll study these problems.  And they will produce the best programs to solve these problems.  All it will take is more government spending.  And how can you refuse?  When people are hungry.  Or homeless.  Or have children that they can’t care for.  How can anyone not want to help the children?  How can anyone not have compassion?

Well, compassion is one thing.  When the innocent suffer.  But when government manufactures that suffering, it’s a different story.  Planned or not the result is the same whenever government tries to fix things.  The cost is high.  The solution is typically worse than the original problem.  And the poorest of the poor are pawns.  To be used by Big Government in the name of compassion. 

Of course, if Big Government were successful in fixing these problems, they would fix themselves right out of existence.  So as long as they want to run Big Government programs, they’ll need a stock of wretched, suffering masses that need their help.  And, of course, lots of crises.

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LESSONS LEARNED #27: “Yes, it’s the economy, but the economy is not JUST monetary policy, stupid.” -Old Pithy

Posted by PITHOCRATES - August 19th, 2010

WHAT GAVE BIRTH to the Federal Reserve System and our current monetary policy?  The Panic of 1907.  Without going into the details, there was a liquidity crisis.  The Knickerbocker Trust tried to corner the market in copper.  But someone else dumped copper on the market which dropped the price.  The trust failed.  Because of the money involved, a lot of banks, too, failed.  Depositors, scared, created bank runs.  As banks failed, the money supply contracted.  Businesses failed.  The stock market crashed (losing 50% of its value).  And all of this happened during an economic recession.

So, in 1913, Congress passed the Federal Reserve Act, creating the Federal Reserve System (the Fed).  This was, basically, a central bank.  It was to be a bank to the banks.  A lender of last resort.  It would inject liquidity into the economy during a liquidity crisis.  Thus ending forever panics like that in 1907.  And making the business cycle (the boom – bust economic cycles) a thing of the past.

The Fed has three basic monetary tools.  How they use these either increases or decreases the money supply.  And increases or decreases interest rates.

They can change reserve requirements for banks.  The more reserves banks must hold the less they can lend.  The less they need to hold the more they can lend.  When they lend more, they increase the money supply.  When they lend less, they decrease the money supply.  The more they lend the easier it is to get a loan.  This decreases interest rates (i.e., lowers the ‘price’ of money).  The less they lend the harder it is to get a loan.  This increases interest rates (i.e., raises the ‘price’ of money). 

The Fed ‘manages’ the money supply and the interest rates in two other ways.  They buy and sell U.S. Treasury securities.  And they adjust the discount rate they charge member banks to borrow from them.  Each of these actions either increases or decreases the money supply and/or raises or lowers interest rates.  The idea is to make money easier to borrow when the economy is slow.  This is supposed to make it easier for businesses to expand production and hire people.  If the economy is overheating and there is a risk of inflation, they take the opposite action.  They make it more difficult to borrow money.  Which increases the cost of doing business.  Which slows the economy.  Lays people off.  Which avoids inflation.

The problem with this is the invisible hand that Adam Smith talked about.  In a laissez-faire economy, no one person or one group controls anything.  Instead, millions upon millions of people interact with each other.  They make millions upon millions of decisions.  These are informed decisions in a free market.  At the heart of each decision is a buyer and a seller.  And they mutually agree in this decision making process.  The buyer pays at least as much as the seller wants.  The seller sells for at least as little as the buyer wants.  If they didn’t, they would not conclude their sales transaction.  When we multiply this basic transaction by the millions upon millions of people in the market place, we arrive at that invisible hand.  Everyone looking out for their own self-interest guides the economy as a whole.  The bad decisions of a few have no affect on the economy as a whole.

Now replace the invisible hand with government and what do you get?  A managed economy.  And that’s what the Fed does.  It manages the economy.  It takes the power of those millions upon millions of decisions and places them into the hands of a very few.  And, there, a few bad decisions can have a devastating impact upon the economy.

TO PAY FOR World War I, Woodrow Wilson and his Progressives heavily taxed the American people.  The war left America with a huge debt.  And in a recession.  During the 1920 election, the Democrats ran on a platform of continued high taxation to pay down the debt.  Andrew Mellon, though, had done a study of the rich in relation to those high taxes.  He found the higher the tax, the more the rich invested outside the country.  Instead of building factories and employing people, they took their money to places less punishing to capital.

Warren G. Harding won the 1920 election.  And he appointed Andrew Mellon his Treasury secretary.  Never since Alexander Hamilton had a Treasury secretary understood capitalism as well.  The Harding administration cut tax rates and the amount of tax money paid by the ‘rich’ more than doubled.  Economic activity flourished.  Businesses expanded and added jobs.  The nation modernized with the latest technologies (electric power and appliances, radio, cars, aviation, etc.).  One of the best economies ever.  Until the Fed got involved.

The Fed looked at this economic activity and saw speculation.  So they contracted the money supply.  This made it hard for business to expand to meet the growing demand.  When money is less readily available, you begin to stockpile what you have.  You add to that pile by selling liquid securities to build a bigger cash cushion to get you through tight monetary times.

Of course, the economy is NOT just monetary policy.  Those businesses were looking at other things the government was doing.  The Smoot-Hartley tariff was in committee.  Across the board tariff increases and import restrictions create uncertainty.  Business does not like uncertainty.  So they increase their liquidity.  To prepare for the worse.  Then the stock market crashed.  Then it got worse. 

It is at this time that the liquidity crisis became critical.  Depositors lost faith.  Bank runs followed.  But there just was not enough money available.  Banks began to fail.  Time for the Fed to step in and take action.  Per the Federal Reserve Act of 1913.  But they did nothing.  For a long while.  Then they took action.  And made matters worse.  They raised interest rates.  In response to England going off the gold standard (to prop up the dollar).  Exactly the wrong thing to do in a deflationary spiral.  This took a bad recession to the Great Depression.  The 1930s would become a lost decade.

When FDR took office, he tried to fix things with some Keynesian spending.  But nothing worked.  High taxes along with high government spending sucked life out of the private sector.  This unprecedented growth in government filled business with uncertainty.  They had no idea what was coming next.  So they hunkered down.  And prepared to weather more bad times.  It took a world war to end the Great Depression.  And only because the government abandoned much of its controls and let business do what they do best.  Pure, unfettered capitalism.  American industry came to life.  It built the war material to first win World War II.  Then it rebuilt the war torn countries after the war.

DURING THE 1980s, in Japan, government was partnering with business.  It was mercantilism at its best.  Japan Inc.  The economy boomed.  And blew great big bubbles.  The Keynesians in America held up the Japanese model as the new direction for America.  An American presidential candidate said we must partner government with business, too.  For only a fool could not see the success of the Japanese example.  Japan was growing rich.  And buying up American landmarks (including Rockefeller Center in New York).  National Lampoon magazine welcomed us to the 90s with a picture of a Japanese CEO at his desk.  He was the CEO of the United States of America, a wholly owned subsidiary of the Honda Motor Company.  The Japanese were taking over the world.  And we were stupid not to follow their lead.

But there was no invisible hand in Japan.  It was the hand of Japan Inc.  It was Japan Inc. that pursued economic policies that it thought best.  Not the millions upon millions of ordinary Japanese citizens.  Well, Japan Inc. thought wrong. 

There was collusion between Japanese businesses.  And collusion between Japanese businesses and government.  And corruption.  This greatly inflated the Japanese stock market.  And those great big bubbles finally burst.  The powerful Japan Inc. of the 1980s that caused fear and trembling was gone.  Replaced by a Japan in a deflationary spiral in the 1990s.  Or, as the Japanese call it, their lost decade.  This once great Asian Tiger was now an older tiger with a bit of a limp.   And the economy limped along for a decade or two.  It was still number 3 in the world, but it wasn’t what it used to be.  You don’t see magazine covers talking about it owning other nations any more.  (In 2010, China took over that #3 spot.  But China is a managed economy.   Will it suffer Japan’s fate?  Time will tell.)

The Japanese monetary authorities tried to fix the economy.  Interest rates were zero for about a decade.  In other words, if you wanted to borrow, it was easy.  And free.  But it didn’t help.  That huge economic expansion wasn’t real.  Business and government, in collusion, inflated and propped it up.  It gave them inflated capacity.  And prices.  And you don’t solve that problem by making it easier for businesses to borrow money to expand capacity and create jobs.  That’s the last thing they need.  What they need to do is to get out of the business of managing business.  Create a business-friendly climate.  Based on free-market principles.  Not mercantilism.  And let that invisible hand work its wonders.

MONETARY POLICY CAN do a lot of things.  Most of them bad.  Because it concentrates far too much power in too few hands.  The consequences of the mistakes of those making policy can be devastating.  And too tempting to those who want to use those powers for political reasons.  As we can see by Keynesian ‘stimulus’ spending that ends up as pork barrel spending.  The empirical data for that spending has shown that it stimulates only those who are in good standing with the powers that be.  Never the economy.

Sound money is important.  The money supply needs to keep pace with economic expansion.  If it doesn’t, a tight money supply will slow or halt economic activity.  But we have to use monetary policy for that purpose only.  We cannot use it to offset bad fiscal policy that is anti-business.  For if the government creates an anti-business environment, no amount of cheap money will encourage risk takers to take risks in a highly risky and uncertain environment.  Decades were lost trying.

No, you don’t stimulate with monetary policy.  You stimulate with fiscal policy.  There is empirical evidence that this works.  The Mellon tax cuts of the Harding administration created nearly a decade of strong economic growth.  The tax cuts of JFK were on pace to create similar growth until his assassination.  LBJ’s policies were in the opposite direction, thus ending the economic recovery of the JFK administration.  Ronald Reagan’s tax cuts produced economic growth through two decades. 

THE EVIDENCE IS there.  If you look at it.  Of course, a good Keynesian won’t.  Because it’s about political power for them.  Always has been.  Always will be.  And we should never forget this.

www.PITHOCRATES.com

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