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Why America is not facing another Great Depression
Gerard Jackson
There is no doubt that Bernanke has been deeply influenced by the great depression. Unfortunately he has no real understanding of what caused it and then prolonged it. It is this lack of understanding that will build up future problems. According to what has become the conventional wisdom the tragedy of the 1930s was caused by the Fed's tardy and inadequate approach to the 1929 crash. If only it had acted sooner — so it is said — and pumped 'liquidity' into the banking system the depression would have been halted in its tracks.
There were about 29,000 banks in 1929, by 1933 the number had dived to 16,000. In December 1928 the money supply1 stood at $46.4 billion. By December 1930 it had fallen to $43.6 even though gold reserves had risen. It reached its lowest point in June 1933 when it came to rest at $30 billion, after which it began to climb.
Although these figures seem to support the view that the problem was the failure of the Fed to support the banks, further examination of the facts reveal otherwise. In February 1930 rediscount rates for the New York Fed were 4.25 per cent. The bank started a process of expansion which had forced the rate down to 2 per cent by the end of the year.
During that whole period member banks experienced a significant increase in their reserves. Nevertheless, this increase was offset by the parlous condition of the banks outside of the reserve, resulting in the money supply falling to $43.6 billion. Having examined the facts, it's clear that there was a determined attempt to inflate the money supply by using "controlled reserves"2.
It was the uncontrolled the reserves that negated the Fed's inflationary policy. People had lost confidence in the banking system. Their demand to hold cash reduced the banks' reserves which in turn shrank the money supply. Not matter how many "controlled reserves" were injected into to banking system they were greatly exceeded by depositors' withdrawals.
Until the Great Depression all depressions were deflationary. The cure was to allow the inflation to work itself by liquidating malinvestments. This process was halted first by Hoover and then by Roosevelt. The consequences of their meddling still casts a shadow over the US economy and helps explain the present financial crisis.
Having misread the lesson of the Great Depression Bernanke, Paulson and a host of other central bankers and treasurers have to all intents and purposes guaranteed the banks' deposits dollar for dollar, even if it means delivering currency in wheelbarrows to depositors' doorsteps. But what would happen if the threat of a mass run on the banks emerged? I believe the government would declare a bank holiday and officially guarantee the deposits. The Fed would rather flood the country with dollars than be blamed for a massive deflation.
So how is the government going to deal with the current crisis. A mass bailout with newly minted dollars is out of the question for now. It could sell off its treasuries and use the money to buy the bad debts, except that it doesn't have enough treasuries at the moment. Then one could use newly minted dollars to buy the bad debts, offsetting the inflationary effect by selling treasuries.
It could be argued that the problem could be solved by simply producing more securities, the sale of which would fund the bailout. However, this would have the effect of forcing down the prices of securities, not something that would appeal to the present holders of securities.
Moreover, as the Fed is targeting the funds rate it needs to act in a way that will not interfere with this policy. To this end it has been suggested that this financial fiasco could be funded by paying interest on deposits made by the commercial banks with the Fed. This would avoid any pressure on interest rates by reducing the banks' "the incentive to lend surplus cash to each other". (Dr Frank Shostak'a admirable Will Paulson’s plan save the US economy?)
That there is a crisis is beyond doubt. The problem is that it has not been properly diagnosed. An inexcusable failure to understand and appreciate the power of money and the way it impacts on the price structure is why we are in this mess. Until this problem is successfully dealt with we will continue to suffer periodic financial crises with the free market being blamed instead of lousy economics.
1. This definition of money includes currency outside of commercial banks, demand deposits or checking accounts of banks and time deposits of commercial banks. Whichever definition is used one more or less gets the same percentage results
2. Controlled reserves are those whose size is directly determined by the policy of Fed and the Treasury.
Gerard Jackson is Brookesnews' economics editor
BrookesNews.Com
Monday 29 September 2008