The Economics Of The Great Depression
Before 1913 the vast majority of loans had been commercial. Loans on nonfarmland real estate and consumer installment credit, like auto loans, were almost nonexistent, and interest rates were very high. But with the advent of the Federal Reserve, credit for cars, homes, and stocks was now cheap and easy.
The effect of low interest rates combined with these new types of loans was immediate - economic bubbles sprang up everywhere. There was the Florida real estate bubble of 1925, and then of course the infamous stock market bubble of the late 1920s.
During the 1920s, many Americans stopped saving and started investing, treating their brokerage account as a savings account, much like many Americans treated their homes in our most recent housing bubble.
But a brokerage account is not a savings account, nor is a house. The value of a savings account depends on how many dollars you put in. But the value of a brokerage account or a house depends solely on the perception of others.
If someone thinks your assets have value, then they do, but if they don’t think they have value, then they don’t.
In a credit-based economy, whether the economy does well or does poorly is largely based on people’s perception. If people believe things are great, then people borrow and spend currency. If they have doubts about the economy, then they save and hoard their money.
In 1929, the stock market crashed, the credit bubble burst, and the U.S. economy slid into a depression.
The popping of a credit bubble is a deflationary event, and in the case of the Great Depression it was massively deflationary. To understand how deflation occurs, you need to know how our currency is born, and how it can disappear.
When we take a loan from a bank, the bank does not actually loan us any of the currency that was on deposit from the bank. Instead, the second someone signs off on a loan, the bank is allowed to create those dollars as a book entry.
In other words, we create the currency, and then the bank gets to charge us interest on the currency we just sprung into existence. This brand new currency we just created then becomes part of the currency supply. Much of our currency supply is created this way. So every time you sign off on a mortgage, car loan, or credit card purchase, currency is brought into existence in your bank’s account sheet.
But when a home goes into foreclosure, a loan gets defaulted on, or someone files bankruptcy, that currency simply vanishes into the ether. So as credit goes bad, the currency supply contracts, and deflation sets in.
This is what happened in 1930-1933, and it was disastrous. As a wave of foreclosures and bankruptcies swept the nation, one-third of the currency supply of the United States evaporated into thin air. Over the next three years, wages and prices fell by one third.
Bank runs are also enormously deflationary events because when you deposit one dollar into the bank, the bank carries that dollar as a liability on its books.
That’s right, your asset is the bank’s liability. Why? Because the bank owes that dollar back to you, should you ever wish to make a withdrawal!
However, under our system of fractional reserve banking, the bank is allowed to create currency in the form of credit (i.e. loans) in an amount many times that of the original deposit, which it carries on its books as an asset.
So under a 10% reserve, a $10 liability can create another $9 of assets for the bank.
This is normally not a problem, as long as the bank isn’t loaned-up to the maximum amount permitted. With just a small amount of “excess” reserves, the bank can cover the day-to-day fluctuations because most of the time deposits and withdrawals come close to balancing out.
But a serious problem can develop when too many people show up to make withdrawals at the same time without the counterbalancing effect of the relatively same amount of people making deposits.
If withdrawals exceed deposits, the bank will draw from those “excess reserves.” But once those excess reserves are used up, fractional reserve banking is thrown into a vicious reverse. From that point on, to be able to pay out $10 against deposits, the bank must liquidate $9 of loans.
This was what was happening in 1931, and it was one of the major contributing factors to the collapse of the U.S. currency supply.
Also, prior to the advent of the Federal Reserve, the public had about one dollar in the bank for each dollar in its pockets, and the banks kept one dollar of reserves on hand to pay out against each $3 of deposits. But thanks to the Federal Reserve, by 1929 the public had $11 in bank deposits for each dollar in its pocket, and the banks only had one dollar on hand to pay out against every $13 in deposits.
This was a very dangerous situation.
The public had lots of deposits and very little cash, and the banks also had very little cash to back up those deposits.
On November of 1930, bank failures were more than double the highest monthly level ever recorded. Over 250 banks with more than $180 million in deposits would fail that month.
But this was only the beginning.
How Bank Runs Affect The Economy
The largest single bank failure in U.S. history happened on December 11, 1930. The sixty-two branch Bank of the United States collapsed. This failure would have a cascading effect, causing over 352 banks with more than $370 million in deposits to fail in that month alone.
Worst of all, this was before deposit insurance. People’s entire life savings were lost in the blink of an eye.
Then, to top it all off, on September 21, 1931, Great Britain defaulted from the gold exchange standard, throwing the world into monetary chaos. Foreign governments, along with businesses and private investors from the United States and around the world, began to fear that the U.S. might follow suit.
Suddenly, there was a dash for cash.
Within the U.S., banks were running out of gold coin, and at the same time tremendous outflows of gold began to leave the vaults of the Federal Reserve, destined for foreign countries. (Its important to note back then that our currency was pegged to gold, so banks were required to have it on hand to pay out against the dollar.)
The pyramid scheme that was the gold exchange standard began to crumble. To stop the bleeding, the Fed more than doubled the cost of currency in the U.S., raising interest rates from 1.5% to 3.5% in one week. As a result, between August 1931 and January 1932, 1,860 banks with $1.4 million in deposits suspended their operations.
However, 1932 was an election year. Three long years into the Depression, people were desperate for a change, and in November, Franklin Delano Roosevelt was elected president.
Even though his inauguration wouldn’t be until March, rumors started flying that he would devalue the dollar. By devaluing the dollar, Roosevelt could offset the deflation that occurred with the currency contraction by causing inflation. Again, gold flowed out of the vaults as foreign governments, foreign investors, and the American public lost even more faith in the dollar, and the most devastating bank run in American history began.
But this time the American public wouldn’t be fooled.
As Barron’s put it in its March 27, 1933 issue:
It has been aptly observed that the stages of deflation since 1929 have been the flight from property (chiefly securities) into bank deposits, next a flight from bank deposits into currency, and finally, a flight from currency to gold.
Incredibly, the currency supply of the United States was falling so fast that if it continued at that pace for a year only 22% of it would remain. The U.S. economic outlook was dire, and it seemed as if the dollar would fall into oblivion.
Roosevelt Takes Action
On March 4, 1933, Roosevelt was inaugurated, and within days he signed executive proclamations closing all banks for a “bank holiday,” freezing foreign exchange, and preventing banks from paying out gold coin when they reopened.
A month later he signed an executive order requiring U.S. citizens to turn over their privately held gold to the Federal reserve, in exchange for Federal Reserve Notes (IOUs).
On April 20, he signed another executive order, ending the right of U.S. citizens to buy or trade in foreign currencies, and/or transfer currency to accounts outside the United States.
On the same day, the Thomas Amendment was sent to Congress, authorizing the president, at his discretion, to reduce the gold content of the dollar to as low as 50% of its former weight in gold. It was enacted into law on May 12, and then amended to give Federal reserve notes the full “lawful money” status.
But there was still one major hurdle to overcome before Roosevelt could devalue the dollar: the infamous gold clause.
During the Civil War, President Abraham Lincoln had to come up with a way to pay the troops and introduced a second purely fiat currency to the country - the greenback dollar. When it first appeared, the greenback was worth the same amount as gold notes. But by the end of the Civil War, they had fallen to just one third of the value of the gold-backed dollar.
Many people who had made contracts or taken out loans before the war in gold notes paid them back in depreciated greenback dollars. Of course this was cheating the creditors and many lawsuits were filed.
After the end of the Civil War, most contracts contained a “gold clause” to protect lenders and others from currency devaluation. The gold clause required payment in either gold or an amount of currency equal to the “weight of gold” value when the contract was entered into.
The Government Steals From Its People
The big problem for Roosevelt was that most government contracts and obligation also had this clause written into them. So devaluing the dollar would also increase the cost of government obligations by the same amount.
So at the behest of President Roosevelt, Congress passed a joint resolution on June 5 defaulting on the gold clause in all contracts, public and private, past, present, and future.
In essence, the government simply said to American citizens and businesses “We don’t have to pay you.”
Outraged by what he viewed as the government’s blatant disregard for American’s rights, Senator Carter Glass, chairman of the Senate Finance Committee, lamented:
“It’s dishonor, sir. This great government, strong in gold, is breaking its promises to pay gold to widows and orphans to whom it has sold government bonds with a pledge to pay gold coin of the present standard of value. It’s dishonor, sir.”
But Senator Thomas Gore of Oklahoma put it even more succinctly when he said:
“Why, that’s just plain stealing, isn’t it, Mr. President?”
But these protest fell on deaf ears. On August 28, 1933, Roosevelt signed Executive Order 6260, outlawing the constitutional right of U.S. citizens to own gold. To keep from having to default on its commitments (i.e. declare bankruptcy), and to keep concealed the fraud of fractional reserve banking, the banking system’s only choice was to get the government to make gold (the legal money of our constitution) illegal for U.S. citizens to own.
Roosevelt gladly obliged.
First under threat of publishing the “gold hoarders” names in the newspaper, and then under threat of fines and imprisonment, the United States of America, land of the free and home of the brave, ordered its citizens to turn over their private property (the money in their pockets) to any Federal Reserve Bank. The government was no longer a government of the people, by the people, and for the people. Instead it was a government of the bankers, by the bankers, and for the bankers.
But it wasn’t over yet.
On January 31, 1934, Roosevelt signed an executive proclamation effectively devaluing the dollar. Before this proclamation it took $20.67 to buy one troy ounce of gold. But now, since the dollar instantly had 40.09% less purchasing power, it took $35 to buy the same amount of gold.
This also meant that, with regards to international trade, the government had just stolen 40.09% of the purchasing power for the entire currency supply of the people of the United States - all with the stroke of a pen.
By devaluing the dollar, the value of the gold held by the U.S. Treasury now exactly matched the value of the monetary base. This mean the dollar was once again fully backed by gold. To halt the implosion of the U.S. banking system and to regain the trust of our international trading partners, gold had forced government to devalue the currency by stealing from its citizens, and accounted for all the excess currency the banking system had created.
Climbing Out Of The Depression
What got us out of the Great Depression wasn’t the government spending and work programs of the Roosevelt administration, or even World War II, as most people think.
What got us out of the Great Depression was the tremendous influx of gold from Europe.
When the Untied States raised the price of gold by nearly 70% to $35 per ounce, prices of goods and services in the United States didn’t immediately jump by the same 70%.
Remember, thanks to the Roosevelt administration, the dollar was devalued by over 40%. So its purchasing power overseas fell by the same amount, slowing our imports dramatically.
But countries buying from the U.S. now found their currency purchased 70% more U.S. goods than it used to.
Also - when a country fixes its currency to gold, it has to buy or sell as much gold as is offered or demanded to maintain that currency price. Suddenly, all of the gold mining companies around the world were selling their gold to one buyer - the U.S. government.
So this, plus a tremendous trade surplus, accounted for most of the gold inflows from 1934 through 1937.
But in 1938, a new dimension was added. When Germany’s Adolf Hitler annexed Austria, the rest of Europe panicked, fearing the looming threat of war. And there was a transfer of wealth from European investments to U.S. investments as Europe braced for the ravages of World War II.
European consumer goods factories were used to produce guns, ammunition, airplanes, and tanks. Thus, most Europeans had to obtain everyday items from the U.S. So in reality, gold inflows, foreign investment, and war profiteering - not social programs - were what lifted the U.S. out of the Great Depression.
Barack Obama And The New Depression
Some of what you just read might seem eerily similar to what’s going on right now with the current housing crisis.
Many Democrats have been recalling the name of President Roosevelt, claiming that more social programs, public works, and government regulation are the answer to our economic downturn. This includes Barack Obama.
However, as you can see in the history of the Great Depression, Roosevelt’s growing of government is not what delivered the U.S. out of that economic crisis. Free market economics - supply and demand - and America’s manufacturing and export power are what made this country wealthy and healthy again.
All President Roosevelt seemed to achieve from an economic standpoint was robbing Americans of their rightful currency and having government control it.
Now that the government is buying up banks, it has an even easier time for controlling currency than Roosevelt did. But what they plan on doing with it will most likely make our economic situation worse.
Barack Obama wants to make credit easier to get. The problem there is that easy credit is what creates the bubble in the first place. The housing market took a nosedive because credit was too easy to get, and people couldn’t pay off what they owed, causing deflation of the currency, and then causing banks to fold.
By artificially pumping credit back up like Obama wants to do, we are just setting ourselves up for an even bigger deflationary event than the one we just experienced.
Increasing public works and social programs, as Obama has proposed to create jobs, also will not help the economy, because again, they require the government to increase taxes and create more currency to pay for them.
Obama also plans to re-negotiate free trade agreements. Barack Obama sides with the labor unions against free trade, because the Unions look at free trade as a threat to jobs. Obama has made his view clear that free trade with developing countries, and with China in particular, is a kind of scam perpetrated by the wealthy, who reap the benefits while ordinary Americans bear the cost.
It’s an understandable view: how, after all, can it be a good thing for American workers to have to compete with people who get paid seventy cents an hour?
As it happens, the negative effect of trade on American wages isn’t that easy to document. The economist Paul Krugman, for instance, believes that the effect is significant, though in a recent academic paper he concluded that it was impossible to quantify.
But it’s safe to say that the main burden of trade-related job losses and wage declines has fallen on middle- and lower-income Americans. So standing up to China seems like a logical way to help ordinary Americans do better. But there’s a problem with this approach - the very people who suffer most from free trade are often, paradoxically, among its biggest beneficiaries.
The reason for this is simple: free trade with poorer countries has a huge positive impact on the buying power of middle- and lower-income consumers—a much bigger impact than it does on the buying power of wealthier consumers.
The less you make, the bigger the percentage of your spending that goes to manufactured goods—clothes, shoes, and the like—whose prices are often directly affected by free trade.
The wealthier you are, the more you tend to spend on services—education, leisure, and so on—that are less subject to competition from abroad.
In a recent paper on the effect of trade with China, the University of Chicago economists Christian Broda and John Romalis estimate that poor Americans devote around forty percent more of their spending to “non-durable goods” than rich Americans do. That means that lower-income Americans get a much bigger benefit from the lower prices that trade with China has brought.
Then, too, the specific products that middle- and lower-income Americans buy are much more likely to originate in places like China than the products that wealthier Americans buy. Despite a huge increase in imports from China—they sextupled as a percentage of U.S. imports between 1990 and 2006—Chinese products are still concentrated mostly in lower-price markets. (By some estimates, Wal-Mart alone has accounted for nearly a tenth of all imports from China in recent years.)
By contrast, much of what wealthier Americans buy is made in the U.S. or in high-wage countries like Germany and Switzerland. This is obvious when it comes to luxury goods—Louis Vuitton bags, Patek Philippe watches, and so on—but it’s also true of many other goods, like electronics, kitchen appliances, and furniture, categories in which American and European manufacturers have continued to thrive by selling to the high-end market.
According to the Yale economist Peter K. Schott, machinery and electronics products made in developed countries sell in the U.S. for four times the average price of Chinese products. And, since the late nineteen-eighties, that price gap has widened by almost forty percent.
Broda and Romalis, in their recent paper, calculate that between 1999 and 2005 alone the inflation rate for lower-income Americans was almost seven points lower than it was for the wealthiest Americans. That means that free trade with China has made average Americans, at least as consumers, much better off—in the sense that it’s made their dollars go further than they otherwise would have.
Now, there’s a lot that’s left out of this equation, such as the fact that free trade may help richer Americans by increasing corporate profits by outsourcing manufacturing to China. And cheap DVD players may not, on balance, make up for lost jobs.
But the reality is that if we toughen our trade relations with China the benefits will be enjoyed by a few, since only a small percentage of Americans now work for companies that compete directly with Chinese manufacturers, while average Americans will feel the pain—in the form of higher prices—far more quickly and more directly than rich Americans will. Obama in his desire to help working Americans—and gain their votes—is pushing for policies that will also hurt them.
The way to get out of any financial crisis is not to increase spending and reduce free trade. It is to lower taxes, lower spending, and allow as much free trade as possible until the markets correct themselves. This has always been the case throughout history, and it is still the case today.