With all his scholarly study
of the Great Depression, Prof. Bernanke is blind to several truly major
factors that caused the Great Depression. His is a blindness that he shares
with very many other economists of this day and age. Their condition can be
described as "a certain state of mind" that they share that
prevents them from seeking out, seeing and saying what is before their eyes.
And what is this state of mind? It is to defend the status quo and to
stay within the comfortable bounds of conventional beliefs that support the
system as it is. This spares them from confronting other institutions and
their own.
Because of this state of mind,
Bernanke doesn’t see or speak of the common features between the latest
banking/real estate fiasco and America’s Great Depression nor, for that
matter, features common to most other of America’s economic collapses
and depressions. These are fractional-reserve banking, bank financing of real
estate and stock speculation, and financial fraud.
By contrast, I point to Prof.
Herbert D. Simpson in a 1933 article in The American Economic Review who
emphasizes these very banking and real estate factors as bringing on the
Great Depression. We now can see that they reappear in the recent past. (Note
that my citing Simpson and other articles below means neither an endorsement
of everything that the authors posit nor that our own bout of speculation
follows the earlier episode precisely.)
Simpson’s article is titled
"Real Estate Speculation and the Depression". He relates that the
1920s was a period of "sensational real estate speculation". This
is a fact that he takes as given, but he merely gives an example:
"In Cook County, outside
of Chicago, we had, in 1928, 151,000 improved lots and 335,000 vacant. On the
basis of our Regional Plan Commission's estimates of future population
increase, it will take until 1960 to absorb the vacant lots al-ready
subdivided in 1928. In fact, on the basis of these computations, we shall
still have 25,000 of these vacant lots for sale in the summer of 1960. In one
township, Niles Township, we have a population of
9,000, and enough vacant lots for a population of 190,000."
In support of Simpson, the
Baker Library at Harvard writes of "The Forgotten Real
Estate Boom of the 1920s", stating
"The famous stock market
bubble of 1925–1929 has been closely analyzed. Less well known, and far
less well documented, is the nationwide real estate bubble that began around
1921 and deflated around 1926."
Most accounts of the 1920s
mention this boom, but it has not yet influenced the thought of most modern
economists. They prefer other stories, such as that of Friedman and Schwartz,
which blames the FED for not inflating. Actually, it did inflate, as Gary North
explains. Even though real estate is a sector of economy-wide importance,
today’s economists tend to ignore its functioning because of the
relative lack of data. Real estate hardly rates an entry in a macroeconomics
textbook. They have been also trained to put on blinders and ignore land,
ever since neoclassical economics invalidly collapsed land as a factor into
capital (see Mason
Gaffney for a detailed account.) Furthermore, another part of their state
of mind is to think only in terms of aggregate demand, a blanket under which
the real estate market and real estate speculation lie submerged and hidden.
For recent support for
Simpson, there is the 2010 paper by William Goetzmann and Frank Newman titled
"Securitization
in the 1920's". The latter study backs up Simpson’s conclusion
that there had been rampant real estate speculation. Goetzmann and Newman
write
"The present crisis is
not the first time that the real estate securities market has expanded to the
brink of collapse. The U.S. real estate securities market was remarkably
complex through the first few decades of the twentieth century. Many
parallels with the modern market can be observed. The early real estate
development industry fed the first retail appetite for real estate
securities. Consequently, easily obtainable financing via public capital
markets corresponded with an urban construction boom...Ultimately, the size,
scope and complexity of the 1920s real estate market undermined its merits,
causing a crash not unlike the one underpinning our current financial
crisis."
The mention of an "urban
construction boom" by this study is what Simpson mentions in his paper
79 years earlier:
"Our latest speculative
movement differs from all previous speculative eras in the United States in
the fact that it has been distinctly an urban field of speculation, ..."
Another recent article that
compares the 1920s to the present is Eugene White’s "Lessons from
the Great American Real Estate Boom and Bust of the 1920s":
"Although long obscured
by the Great Depression, the nationwide ‘bubble’ that appeared in
the early 1920s and burst in 1926 was similar in magnitude to the recent real
estate boom and bust. Fundamentals, including a post-war construction catch-up,
low interest rates and a ‘Greenspan put,’ helped to ignite the
boom in the twenties, but alternative monetary policies would have only
dampened not eliminated it. Both booms were accompanied by securitization, a
reduction in lending standards, and weaker supervision. Yet, the bust in the
twenties, which drove up foreclosures, did not induce a collapse of the
banking system. The elements absent in the 1920s were federal deposit
insurance, the ‘Too Big To Fail’ doctrine, and federal policies
to increase mortgages to higher risk homeowners. This comparison suggests
that these factors combined to induce increased risk-taking that was crucial
to the eruption of the recent and worst financial crisis since the Great
Depression."
White is correct that deposit
insurance, too big to fail, and federal policies have made the present
situation worse than the 1920s, other things equal.
A pervasive 1920s real estate
boom or bubble is consistent with the Austrian analysis in which the banking
system produces fiduciary money, lowers interest rates, and flows it into
assets of long duration whose values are particularly sensitive to interest
rate fluctuations.
Simpson’s analysis
weaves several threads together into one fabric. The central thread is
fractional-reserve banks that finance long-term assets with short-term
deposits:
"Now, when it is recalled
that these were not mortgage banks, organized on principles of long-term
financing, investing their own capital funds, and free from deposit
liabilities, but that they ordinarily purported to be commercial banks,
engaged in accumulating and carrying large deposits, and that their
operations were financed largely through the funds of their depositors, it
will be realized in what a highly over-extended position this segment of our
banking system was placed."
Today’s banks operate on
the same principle of borrowing excessively short and lending excessively
long. The modern system developed an additional layer known as the shadow
banking system, but it too financed excessive amounts of long-term assets
with excessive amounts of short-term liabilities. This has two dangers. One
is that the long-term assets fall in value by more than the value of the
short-term liabilities, which means the bank is insolvent. The other is that
the bank cannot roll over its short-term debts, which happens when the
lenders see that the bank is insolvent. Both of these happened in both booms:
"...all the financial
resources of existing banking and financial institutions were utilized to the
full in financing this speculative movement. The insurance companies bought
what were considered the choicer mortgages; conservative banks loaned freely
on real estate mortgages; and less conservative banks and financial houses
loaned on almost everything else that represented real estate in any
form."
"Eventually we reached a
point where most of the city and outlying banks of the country were loaded
with real estate loans or real estate liabilities of some sort. Not all of
these loans were speculative; many of them were intrinsically sound and
conservative. But a large, probably a major, portion of this loan structure
depended for its solvency upon a continuation of the rate of absorption and
turnover which had characterized the real estate market, and on a continued
advance of real estate values. When the rate of absorption halted and the
price movement stopped, one of the largest categories of bank collateral in
the country went stale, and the banks found themselves loaded with frozen
assets, which we have been trying ever since to thaw out."
Deposit insurance paid for by
banks looks as if it curtails the roll over problem, but it doesn’t. It
works only in good times because the deposit insurance fund is too small to
handle systemic problems. Worse yet, deposit guarantees allow and encourage
banks to become larger and, with lax regulation, more overextended. The basic
problem, which is holding excessive amounts of long-term assets that are
financed by excessive amounts of short-term liabilities, metastasizes. This
is shown by the recent problems and the unprecedented responses of the
government. In the latest crisis, the federal government stepped in to
guarantee money market funds, both retail and institution. It also began
financing banks through the Troubled Asset Relief Program (TARP). The FDIC
got involved in financing banks through the Temporary Liquidity Guarantee
Program (TLGP). The FED did all sorts of financing including a Commercial
Paper Funding Facility and special funding for some financial intermediaries
like AIG and Bear Stearns.
Simpson’s article views
the banks and their real estate financing as a major cause of the subsequent
depression:
"We do not have all the
facts and figures, and in the nature of things probably will never have them.
But it would seem that we can safely say this much: that real estate, real
estate securities, and real estate affiliations in some form have been the
largest single factor in the failure of the 4,800 banks that have closed
their doors during the past three years and in the ‘frozen’
condition of a large proportion of the banks whose doors are still open; and
that as the facts of our banking history of the past three years come to
light more and more, it becomes increasingly apparent that our banking
collapse during the present depression has been largely a real estate
collapse."
A boom by definition involves
an expansion. The expansion process is not what causes a boom, but it helps
us to perceive the parallels between the 1920s and now to observe that the expansion
process was similar in the past and present. In the real estate boom of the
1990s and 2000s, we saw not only the existing banks and institutions like
Fannie Mae and Freddie Mac become more aggressive, we also saw new kinds of
financial intermediaries spring up. New kinds of financing methods were also
used to create mortgages, package them and distribute them to investors
aggressively. These developments are not unlike those in the 1920s:
"A particularly ominous
development was the expansion of the banking system itself for the specific
purpose of financing real estate promotion and development. Real estate
interests dominated the policies of many banks, and thousands of new banks
were organized and chartered for the specific purpose of providing the credit
facilities for proposed real estate promotions. The greater proportion of
these were state banks and trust companies, many of them located in the
outlying sections of the larger cities or in suburban regions not fully
occupied by older and more established banking institutions. In the extent to
which their deposits and resources were devoted to the exploitation of real
estate promotions being carried on by controlling or associated interests,
these banks commonly stopped short of nothing but the criminal law and
sometimes not short of that."
Simpson alludes to illegality
and fraud. These too were a serious part of the
1990s and 2000s (see
here).
Ben Bernanke in 1983 in The
American Economic Review published "Nonmonetary Effects of the
Financial Crisis in the Propagation of the Great Depression". This paper
is not intended to examine the causes of the Great Depression and it does not
do so. It’s about the depression’s propagation. Bernanke
points out that
"...the disruption of the
financial sector by the banking and debt crises raised the real cost of
intermediation between lenders and certain classes of borrowers."
He means that the credit
market slowed down to a crawl:
"Fear of runs led to
large withdrawals of deposits, precautionary increases in reserve-deposit
ratios, and an increased desire by banks for very liquid or rediscountable
assets. These factors, plus the actual failures, forced a contraction of the
banking system's role in the intermediation of credit."
Twenty-five years later,
Bernanke was in a position in a new banking crisis
to replace a new set of failed intermediaries with the Federal Reserve. In
the intervening years, the non-Austrian economics profession had done nothing
to focus on the causes of the banking failures and nothing to educate
government officials about how to remedy those causes.
Despite not having sought or
found the causes of the depression, Bernanke was not reluctant to take the
position that the "financial structure" lacked
"self-correcting powers", or in other words that the free market
had failed. He was far from reluctant to argue instead
"...that the federally
directed financial rehabilitation – which took strong measures against
the problems of both creditors and debtors – was the only major New
Deal program that successfully promoted economic recovery,"
and to argue that "the
government’s actions set the financial system on its way back to
health."
On what basis could Bernanke
know what a healthy bank looks like without analyzing what an unhealthy bank
looks like and how it got that way, namely by excessively financing real
estate loans with short-term deposits flowing through the banking system due
to a generous Federal Reserve? On what basis could Bernanke blame banks for
being reluctant to lend when (a) they were insolvent, and (b) business was
poor due to such benighted federal policies as Hoover’s efforts to keep
wages high, the Smoot-Hawley Tariff, and a bevy of major New Deal programs,
some of which strengthened trade unions and held wages up? On what grounds
could Bernanke blithely extol government for having
"...made investments in
the shares of thrift institutions, and substituted for recalcitrant private
institutions in the provision of direct credit. In 1934, the
government-sponsored Home Owners’ Loan Corporation made 71 percent of
all mortgage loans extended."
None of these government actions
resolved the basic banking and money problems. All of them socialized
finance. All of them led to new problems, including the establishment of
Fannie Mae in 1938.
In 1995, Bernanke published
"The Macroeconomics of the Great Depression: A Comparative
Approach" in The Journal of Money, Credit and Banking. He began
by saying that
"TO UNDERSTAND THE GREAT
DEPRESSION is the Holy Grail of macroeconomics."
As in his 1983 paper, however,
Bernanke seals off the 1930s from the 1920s. He tells us that "finding
an explanation for the worldwide economic collapse of the1930s remains a
fascinating intellectual challenge," but apparently it’s not
fascinating enough to examine the effects of the real estate and stock market
booms of the 1920s, or entertain the Austrian theory of malinvestment, or
reference Rothbard’s America's
Great Depression, or examine the structure of banks, or think about
the integration of the world economy via its banks and capital markets.
What then is Bernanke’s
understanding of the Great Depression? It is
"...that monetary shocks
played a major role in the Great Contraction, and
that these shocks were transmitted around the world primarily through the
workings of the gold standard..."
By monetary shocks, he means
that the money supply contracted. We already know that this happened when the
banking system became insolvent. It raises several pertinent questions that
Bernanke ignores. Did the money supply grow excessively in the 1920s
before it contracted, and why did the banking system become insolvent? What
did they invest in and how did they finance those investments such that they
eventually became insolvent? Rothbard and Benjamin M. Anderson
both show that money grew rapidly in the 1920s, and as explained above so did
the banks’ investments in real estate. In Economics
and the Public Welfare, Anderson writes
"The purchase of
approximately $500 million worth of government securities by the Federal
Reserve banks...The total deposits of the member banks increased from
$28,270,000,000 on March 31, 1924, to $32,457,000,000 on June 30, 1925, an
increase of over $4 billion...This additional bank credit was not needed by
commerce and it went preponderantly into securities: in part into direct bond
purchases by the banks and in part into stock and bond collateral loans. It
went also into real estate mortgages purchased by banks and in part into
installment finance paper. This immense expansion of credit, added to the
ordinary sources of capital, created the illusion of unlimited
capital..." (pp. 127—28.)
He also writes
"There is no need
whatever to be doctrinaire in objecting to the employment of bank credit for
capital purposes, so long as the growth of this is kept proportionate to the
growth of the industry of the country...But when in the period 1924—29
there came an extraordinary spurt of this kind of employment of bank funds,
and when commercial loans began going down in the banks at the same time that
the stock market loans and bank holdings of bonds were mounting rapidly, the
careful observer grew alarmed. And when in addition there came a startling
increase of several hundred percent in bank holdings of real estate
mortgages, the thing seemed extremely ominous." (p. 135.)
As for Bernanke’s
statement about "the workings of the gold standard", there was no
traditional gold standard in the 1920s and 1930s. There was a gold-exchange
standard. If a standard is to be blamed, it is the latter, not the
gold standard. Murray Rothbard has
explained the inflationary workings of the gold-exchange standard. Another
source is The
Great Depression by Lionel Robbins. Both emphasize Great
Britain’s futile attempt to peg the pound at its old gold parity.
Bernanke doesn’t reference either Rothbard or Robbins.
Bernanke doesn’t mention
the key bank failure in 1931 that helped to propagate the depression: CREDIT-ANSTALT.
The American money supply had been declining prior to this failure, and it
accelerated its decline thereafter. This failure appears to have been a shock that cannot be ignored. Credit-Anstalt was the
largest bank in Austria and owned about 60 percent of Austrian industry. It
had grown in size due to a large but bad merger. The Austrian economy had had
problems from at least 1924. Behind the scenes, a British and American
consortium of banks had been secretly funneling funds to Credit-Anstalt. Its
failure led to a run on the Austrian shilling. It appears that the
gold-exchange standard had little or nothing to do with these events.
There are several other seeds
to the Great Depression, in my view. They include the Smoot-Hawley Tariff,
Hoover’s high wage policies, and other of his policies that eventually
became New Deal policies. I also believe that the depression became worldwide
because the economy was worldwide, as it is today, and European countries had
banking and other problems that trace back to World War I and its aftermath.
On October 15, 2008, Bernanke
said in a prepared speech:
"As in all past crises,
at the root of the problem is a loss of confidence by investors and the
public in the strength of key financial institutions and markets. The crisis
will end when comprehensive responses by political and financial leaders
restore that trust, bringing investors back into the market and allowing the
normal business of extending credit to households and firms to resume."
This is typical of
Bernanke’s thought, which habitually stops short at asking why events
occur. If he kept asking why, he might eventually get to the heart of the
matter. Why has there been a loss of confidence? It didn’t just happen.
What brought it about? Didn’t investors have good reason to question
key banks and investment banks? Wasn’t there good reason why credit
spreads had risen? Hadn’t housing prices started to drop? Those
declines were real. They cannot be blamed on a loss of confidence. Why
had housing prices declined? Was it perhaps because there had been a housing
boom fueled by federal policies and readily available bank loans, and because
prices had reached unsustainable levels? He doesn’t ask. Don’t
ask, don’t tell.
Bernanke has that
"certain state of mind" by which he cuts inquiry short, never going
beyond the superficial because to do so would being him onto ground that to
him is dangerous. He might have to condemn fractional-reserve banking, or
endemic fraud in the mortgage industry, or his own institution, or lax
federal regulation. So instead, Bernanke blames the Panic of 2008 on a loss
of confidence in banks and markets and tries to get us to believe that the
remedy is a restoration of trust.
That’s only one of his
superficial explanations. The main one is the same one he thinks caused the
Great Depression. He thinks that the central bank didn’t create enough
money in the 1930s. The truth is almost the very opposite. Inflation of money
in the 1920s worked its way through the banking system and into an
unsustainable real estate boom and a stock market bubble. The problem was not
too little money. It was too much. The world experienced a repetition of this
high money growth between 2002 and 2008 (and before) as I have elsewhere
shown. Another real estate bubble occurred. We are living in its aftermath.
Bernanke’s additions of
huge amounts of base money, which are his solutions, do not solve the basic
problems which are the structure of banks and the structure of fiat money.
Unfortunately,
Bernanke’s blindness is not unique among today’s economists. Many
of them believe the same thing. Several Federal Reserve presidents are
prepared to inject
even more base money into the American and world economy. There is no money
supply reason for doing so, because the money supply has already soared in
the last few years. There is no reason relative to the economy for doing so,
because the soaring money supply has had negligible effects on economic
growth and unemployment. These bankers seem to have gone Bernanke one better.
He is blind, but they’ve taken complete leave of their senses.
Originally
published at LewRockwell here
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