The Revisionist Theory and History of Depressions

An accounting principle, the Law of Liabilities, asserts that a firm ought to carry itsliabilities in the balance sheet at its value upon maturity, or at liquidation value,whichever is higher. This Law is ignored by present accounting standards. The result is arise in the liquidation value of debt, erosion of depreciation quotas, and wholesaledestruction of capital under a falling interest-rate structure caused by a faulty monetarypolicy, hailed as the savior, but which should be condemned as the destroyer.

Recognizing the Law of Liabilities may help us to understand deflations and depressionsbetter.

The Book-Keeper’s Dilemma

One of the plays of George Bernard Shaw branded “unpleasant” by the playwright himself isentitled The Doctor’s Dilemma. The protagonist is a physician who comes into conflict withthe Oath of Hippocrates (fl. 460-377 B.C.) He has developed a new treatment for a fataldisease, but the number of volunteers for the test-run exceeds the number of beds in his clinic.

Unwittingly, the doctor finds himself in the role of playing God as he decides who shall liveand who shall die.

By the same token a “most unpleasant” play could be written entitled The Book-Keeper’s Dilemma. The protagonist, a chartered accountant, finds himself in conflict with theletter and spirit of book-keeping as set out by Luca Pacioli (fl. 1450-1509). As a result ofcompromising the high standards of the accounting profession, the book-keeper becomes thedestroyer of Western Civilization. This play is, in effect, being written by history right now.

————————————

This is an updated version of my paper written a year ago: Is Our Accounting SystemFlawed? – It may be insensitive to capital destruction. Up-dating was prompted by eventsduring that fateful year. In several passages I had to change the subjunctive mood to theindicative: the hypothetical depression has, unfortunately but not unpredictably, becomean actual depression.

2Finest product of the human brain

Luca Pacioli taught mathematics at all the well-known universities of Quattrocento Italyincluding that of Perugia, Napoli, Milan, Florence, Rome, and Venice. In 1494 he publishedhis Summa Arithmetica, Tractatus 11 of which is a textbook on book-keeping. The authorshows that the assets and liabilities of a firm must balance out at all times, provided that weintroduce a new item in the liability column that has been variously called by subsequentauthors “net worth”, “goodwill”, and “capital”. This innovation makes it easy to check theledger for accuracy by finding that, at the close of every business day, assets minus liabilitiesis equal to zero. If not, there must be a mistake in the calculation.

But what Pacioli discovered was something far more significant than a method offinding errors in the arithmetic. It was the invention of what we today call double-entry bookkeeping,and what Göthe has called “the finest product of the human brain” (WilhelmMeister’s Apprenticeship.)Why was this discovery so important in the history of Western Civilization? Because,for the first time ever, it was possible to calculate and monitor shareholder equity withprecision. This is indispensable in starting and running a joint-stock company. Without it newshareholders could not get aboard, and old ones could not disembark safely. There would beno stock markets. The national economy would be a conglomeration of cottage industries,unable to undertake any large-scale project such as the construction of a transcontinentalrailroad, or the launching of an intercontinental shipping line.

The invention of the balance sheet did to the art of management what the invention ofthe compass did to the art of navigation. Seafarers no longer had to rely on clear skies in orderto keep the right direction. The compass made it possible to sail under cloudy skies with equalconfidence. Likewise, managers no longer have to depend on risk-free opportunities to keeptheir enterprise profitable. The balance sheet tells them which risks they may take and whichones they must avoid. It is no exaggeration to say that the present industrial might of WesternCivilization rests upon the corner-stone of double-entry book-keeping. Oriental (Chinese) andMiddle-Eastern (Arab) civilizations would have outstripped ours if they had chanced upon thediscovery of the balance sheet first. By the same token, the continuing leadership of the Westdepends on keeping accounting standards high and isolated from political influences.

Barbarous relic or accounting tool?

There is cause for concern in this regard. For the past 75 years the West has been fed thepropaganda line, attributed to John Maynard Keynes, that the gold standard is a “barbarousrelic”, ripe to be discarded. The unpleasant truth, one that propagandists have ‘forgotten’ toconsider, is that the gold standard is merely a proxy for sound accounting and, yes, for soundmoral principles. It is an early warning system to indicate erosion of capital. It was not thegold standard per se that politicians and adventurers wanted to overthrow. They wanted to getrid of certain accounting and moral principles, especially as they apply to government andbanking, that had become an intolerable fetter upon their ambition for aggrandizement andperpetuation of power. Historically, accounting and moral principles had been singled out fordiscard before the gold standard was given the coup de grâce.

The attack on accounting standards and on the gold standard was heralded by theestablishment in 1913 of the Federal Reserve (F.R.) System in the United States, the chiefengine of monetizing government debt followed, a decade later, by the illegal introduction of‘open market operations’. Open market operations were not authorized by the F.R. Act of1913. In fact, progressive penalties were levied on F.R. banks that could only cover theirliabilities incurred upon issuing F.R. credit by assets in the form of U.S. Treasury paper.

3‘Eligible paper’ was defined in the Act as short-term commercial bills of exchange, to theexclusion of Treasury bills, notes, and bonds. The F.R. Act was later amended legalizing openmarket operations ex post facto.

Bond speculators were quick to realize that risk-free profits could be made by preemptingthe F.R. banks’ purchases of Treasury paper in the open market. Bullish speculation,risk-free, in Treasury bills, notes, and bonds ultimately drove down interest rates to near zero,resulting in the destruction of capital, as explained below. Just how the monetization ofgovernment debt has led to a hitherto unprecedented, even unthinkable, corruption ofaccounting standards ― this is a question that has never been addressed by impartialscholarship before.

Bonds and the Wealth of Nations

In order to see the connection we must recall that any change in interest rates has a direct andimmediate effect on the value of financial assets. Rising interest rates make the value of bondsfall, and falling rates make it rise. As a result of this inverse relationship the Wealth ofNations would flow and ebb together with the variation of the rate of interest. Benefits andpenalties would be distributed capriciously and indiscriminately, without regard to merit. Itfollows that the world economy needs a ‘flywheel regulator’ to keep interest rates stable or,more precisely, to let the increase in the Wealth of Nations impart a rather gentle and slowfalling trend to interest rates.

That flywheel regulator was the gold standard before it was forcibly removed anddiscarded by irresponsible politicians trampling on the Constitution of the United States.

Under the gold standard the rate of interest was stable and violent contractions in the Wealthof Nations were unknown. A lasting increase in the rate of interest could only occur in thewake of a natural disaster such as an earthquake, flood, or crop failure. Remarkably, thesewere cushioned by the spreading of the impact from the stricken country to the community ofgold standard nations. War destruction would also cause the rate of interest to rise. In all thesecases a higher rate of interest was beneficial. It had the effect of spreading the loss of wealthdue to destruction of property more widely, easing the burden on individuals. Those segmentsof society, or those countries, that were lucky enough to escape physical destruction had toshare in the loss through paying the increased cost of servicing capital due to higher interestrates. Everyone was prompted to work and save harder in order that the damage might berepaired quickly and expeditiously. As the rate of interest gradually returned to its originallevel, the Wealth of Nations expanded. Once again, everybody shared equally as the lowerinterest rate benefited all through the reduction in the cost of servicing capital.

It is not widely recognized that the chief eminence of the gold standard is not to befound in stabilizing the price structure (which is neither desirable nor possible). It is to befound in stabilizing the interest-rate structure. By ruling out capricious and disturbing swings,the Wealth of Nations is maximized.

The gold standard ruled supreme before World War I. It was put into jeopardy whengeneral mobilization was ordered in 1914 by the manner in which belligerent governments setout to finance their war effort. These governments wanted to perpetuate the myth that the warwas popular and there was no opposition to the senseless bloodshed and destruction ofproperty that could have been avoided through better diplomacy. The option of financing thewar through taxes was ruled out as it might make the war unpopular. The war was to befinanced through credits. In more details, war bonds were issued in unprecedented amounts,subsequently monetized by the banking system. Naturally, these bonds could not possibly besold without a substantial advance in the rate of interest. Accordingly, the Wealth of Nationsshrank even before a single shot was fired or a single bomb dropped.

Sinking fund protection

Under the gold standard bondholders were protected against a permanent rise in the rate ofinterest (which in the absence of protection would decimate bond values) by the provision of asinking fund. In case of a fall in the value of the bond the sinking fund manager would enterthe bond market and would keep buying the bond until it was once more quoted at par value.

Every self-respecting firm selling its bonds would offer sinking-fund protection.

Even though governments did not offer it, it was understood and, in the case ofScandinavian governments explicitly stated, that the entire bonded debt of the governmentwould be refinanced at the higher rate, should a permanent rise in the rate of interest occur.

Bondholders who have put their faith in the government would not be allowed to sufferlosses. Banks, the guardians of the people’s money, could regard government bonds as theirmost trusted earning asset. They were solid like the rock of Gibraltar. Such faith, at least inScandinavian government obligations, was justified. The risk of a collapse in their value wasremoved. Governments, at least those in Scandinavia, occupied the moral high ground. Themoney they borrowed belonged, in part, to widows and orphans. They took to heart theScriptural admonition and did not want to bring upon themselves the curse pronounced ontormentors of widows and orphans.

Law of Assets

However, there was a problem with war bonds issued by the belligerent governments. Theywere quickly monetized by the banking system making the refinancing of bonded debtimpossible. This created a dilemma for the accounting profession. According to an old bookkeepingrule going back to Luca Pacioli that we shall here refer to as the Law of Assets, anasset must be carried in the balance sheet at acquisition value, or at market value, whicheveris lower. In a rising interest-rate environment the value of bonds and fixed-income obligationsare falling, and this fall must be faithfully recorded in the balance sheet of the bondholder.

There are excellent reasons for this Law. In the first place it is designed to preventcredit abuse by the banks and other lending institutions. In the absence of this Law bankscould overstate the value of their assets that might be an invitation to credit abuses to thedetriment of shareholders and depositors. If the abuse went on for a considerable period oftime, then it could lead to the downfall of the bank. In an extreme case, when all banksdisregarded the Law of Assets, the banking system could be operating on the strength ofphantom capital, and the collapse of the national economy, to say nothing of the worldeconomy, might be the ultimate result. For non-banking firms the danger of overstating assetvalues also exists, and can serve as an invitation to reckless financial adventures. Even if weassumed that upright managers would always resist the temptation and stay away fromdubious adventures, in the absence of the Law of Assets the balance sheet would be anunreliable compass to guide the firm through turbulence, materially increasing the chance ofmaking an error. Managerial errors could compound and the result could again be bankruptcy.

Economists of a statist persuasion would argue that an exception to the Law of Assetscould be safely made in case of government bonds. The government’s credit, like Caesar’swife, is above suspicion. The government will never go bankrupt. Its ability to retire debt atmaturity cannot be doubted. As a guarantee these economists point to the government’s powerto tax. However, the problem is not with paying the face value of the bond at maturity, butwith the purchasing power of the proceeds. By that standard, the U.S. government is guilty ofpartial and concealed default on every single 30-year bond it has sold since the opening of thedoors of the F.R. banks for business in 1914. Currency depreciation is a more subtle and,5hence, a more treacherous form of default. Governments, however powerful, cannot createsomething out of nothing any more than individuals can. They cannot give to Peter unlessthey have taken it from Paul first. Nor is the taxing power of governments absolute. Financialannals abound in cases where taxpayers have revolted against high or unreasonable taxes,sometimes overthrowing the government in the process. If the taxing power of governmentshad been absolute, then they could have financed World War I out of taxes. Bondholderswould have suffered no loss of purchasing power, at least not on the victors’ side.

It is true that governments as a rule do not go bankrupt, but this may be adisadvantage. Putting a value on bonds higher than what they would fetch in the market is afool’s paradise. Governments could use methods, fair or foul, to stave off the ill effects oftheir own profligacy. Awakening could be postponed, but it would be made that much ruder.

A strict application of the Law of Assets would have made most banks and financialinstitutions in the belligerent countries insolvent. The dilemma facing the accountingprofession was this. If accountants and book-keepers insisted that the Law be enforced, theywould be called “unpatriotic” and be made a scapegoat held responsible for the weakeningfinancial system. Demagogues would charge that they were undermining the war effort. Onthe other hand, if the accountants allowed the banks to carry government bonds in the assetcolumn at acquisition rather than at the lower market value, then they would compromise thetime-tested standards of accounting and expose the bank, and ultimately the nationaleconomy, to all the dangers that follows from this, not to mention the fact that they would alsodraw the credibility of the accounting profession into question.

Illiquid or insolvent?

The story how the accounting profession solved the dilemma has never been told. It may be asafe assumption that the dilemma was solved for it by the belligerent governments inprohibiting the public disclosure of the banks’ true financial condition. A new accountingcode was created, far more lenient in adjudicating insolvency. The Law of Assets was thrownto the winds, replaced with a more relaxed one allowing the banks to carry government bondsat face value, regardless of true market value, as if they were a cash item. A new term wasinvented to describe the financial condition of a bank with a hole in the balance sheetpunctured by the falling value of government bonds. Such a bank was henceforth considered“illiquid”, but still solvent. Never mind that the practice of allowing the illiquid bank to keepits door open was a dangerous course to follow. It had far-reaching consequences, including athreat to the very foundations of Western Civilization. It was a death sentence on the goldstandard with a stay of execution. It was throwing the gates open to wholesale currencydebasement world-wide. It is no exaggeration to say that the present unprecedented financialcrisis is another delayed effect of the unwarranted relaxation of accounting standards back in1914.

While I cannot prove that a secret gag-rule was imposed on the accounting profession,I am at a loss to find an explanation why an open debate on the wisdom of changing timehonoredaccounting principles has never taken place. Apparently there were no defectionsfrom the rank and file of accountants in denouncing the new regimen as dangerous andunethical. The underhanded changes in accounting practice have opened the primrose path toself-destruction.

The dominant role of the West in the world was due to the moral high ground stakedout by the giants of the Renaissance, among them Luca Pacioli. As this high ground wasgradually given up, and the commanding post was moved to shifting quicksand, rock-solidprinciples gave way to opportunistic guidelines. Western Civilization has been losing its claim6to leadership in the world. It comes as no surprise that this leadership is now facing its mostserious crisis ever.

The chickens came home to roost as early as 1921 when panic swept through the U.S.

government bond market. All banks found that their capital was seriously impaired as a resultof the panic. Financial annals fail to deal with this crisis (exception: B. M. Anderson’sFinancial and Economic History of the United States, 1914-1946, posthumously published in1949, see reference at the end). Nor was it given the coverage it deserved in the financialpress. Information was confined to banking circles. An historic opportunity was missed tomend the ways of the world gone astray in 1914. It was the last chance to avert the GreatDepression of 1930 already in the making, to say nothing of other great depressions to follow.

Law of Liabilities

Purely by using a symmetry argument we may formulate another fundamental principle ofaccounting: the Law of Liabilities. It asserts that a liability must be carried in the balancesheet at its value at maturity, or at liquidation value, whichever is higher. Since liquidationwould have to take place at the current rate of interest, in a falling interest-rate environmentthe liabilities of all firms are rising. The reason for this Law is to prevent the government,banks, and other firms from understating their liabilities that would spell a great danger to thenational economy. This danger has been completely disregarded by the profession of theeconomists, as it has by that of the accountants.

Economists have failed to raise their voice against the folly of allowing the interestratestructure to fluctuate for reasons of political expediency, implicit in the application ofboth Keynesian and Friedmanite nostrums. It is possible that the reason for this failure wasthe fatal blind spot that economists appear to have in regard to the danger of overestimatingnational income in a falling interest-rate environment.

The proposition that a firm ought to report liabilities at a value higher than the amountdue at maturity whenever the rate of interest falls is, of course, controversial. Let us reviewthe reasons for this crucial requirement. If the firm is to be liquidated, then all liabilitiesbecome due at once. Sound accounting principles demand that sufficient capital be maintainedat all times to make liquidation without losses possible. If the rate of interest were to fall,then, clearly, earlier liabilities had been incurred at a rate higher than necessary. For example,if an investment had been financed through a bond issue or fixed-rate loan, then better termscould have been secured by postponing it. A managerial error in timing the investment hadbeen made. This is a world of crime and punishment where even the slightest error bringswith it a penalty in its train. Marking the liability in the balance sheet to market is the penaltyfor poor timing. If the investment had been financed out of internal resources, the penalty wasstill justified. Alternative uses for the resource would have generated better financial results.

Even if we assume that the investment was absolutely essential at the time it wasmade, and we absolve management of all responsibility in this regard, the case for an increasein liability still stands. After all has been said and done, there is a loss that must not be sweptunder the rug. If the balance sheet is to reflect the true financial position, then the loss oughtto be realized. Any other course of action would create a fool’s paradise.

To see this clearly, consider losses due to accidental fire destroying physical capitalnot covered by insurance. The loss must be realized as it is necessary that the balance sheetreflect the changed financial picture caused by the fire. That’s just what the balance sheet isfor. The proper way to go about it is a three-step adjustment as follows:(1) Create an entry in the asset column called “capital fund to cover fire loss”.

7(2) Create an equivalent entry in the liability column.

(3) Amortize the liability through a stream of payments out of future income.

It is clear that if the accountant failed to do this, then he would falsify all subsequent incomestatements. As a result losses would be reported as profits and phantom profits would be paidout as dividends. Not only would this weaken the financial condition of the firm, but it wouldalso render the balance sheet meaningless, which may compound the error further.

Exactly the same holds if the loss was due not to accidental fire but to a fall in the rateof interest. The way to realize the loss is analogous. A new entry in the asset column must becreated under the heading “capital fund to cover shortfall in capitalizing interest payments,and shortfall in depreciation quotas, due to the fall of the interest rate”, against an equivalententry in the liability column, to be amortized through a stream of payments out of futureincome. This is not an exercise in pedantry. It is the only proper way to realize a loss that hasbeen incurred as a result of the inescapable increase in the cost of servicing productive capitalalready deployed, in the wake of a fall in the rate of interest. Ignoring that loss would by nomeans erase it. It may well compound it.

The effect of falling interest rate on depreciation schedules

When a firm acquires a capital good, it adds its value to the asset column of the balance sheet,while charging the same amount to the liability column. The liability must be amortizedduring the productive life of the asset. In other words, asset values are subject to depreciation,set forth in the depreciation schedule, specifying depreciation quotas year by year and item byitem. Asset depreciation and liability amortization are the opposite sides of the same coin.

If the rate of interest is stable, then the depreciation schedule is fixed. However, if therate of interest falls, the depreciation quota will be insufficient to do the necessaryamortization. At the end of the productive life of the asset there will remain an unamortizedliability. The depreciation schedule, in exactly the same way as a bond sold, is a liability ofthe firm which increases whenever the rate of interest decreases, as explained above.

If adjustment is not made, then, according to the Law of Liabilities, the balance sheetwill falsify the position of the firm by showing assets of zero value at positive valuation.

Worse still, the profit/loss statement is also falsified, masking losses as profits.

Therefore it is incumbent on the accountant to rewrite the depreciation schedule byincreasing depreciation quotas to reflect the fall in interest rates, regardless whether thepurchase of the asset was financed through issuing debt, equity, or through funds generatedinternally. There is an increase in liability that has to be amortized by a further charge againstfuture income.

Present accounting standards ignore the need to revise depreciation quotas upon a fallin interest rates. They allow firms to pay out phantom profits as dividends. The result is:destruction of capital which remains hidden. The balance sheet and the profit/loss statementcease to be a faithful guide to show the real picture. The larger the asset values involved are,the greater capital destruction is. Note that all firms are hit simultaneously by the erosion ofcapital, which makes the crisis more acute when the day of reckoning dawns, that is, whencapital destruction can no longer be concealed.

The example of Japan

I anticipate a torrent of criticism asserting that there is no such a thing as the Law ofLiabilities in accounting theory or practice. I submit that I have no formal training inaccounting, or in the theory and history of accounting. Nor do I recall having seen the Law of8Liabilities in any of the textbooks on book-keeping that I have perused (although I have seenthe Law of Assets in older textbooks that have long since been discarded). But I shall arguethat either Law follows the spirit if not the letter of Luca Pacioli. Affirming one while denyingthe other makes no sense. Every argument that supports one necessarily supports the other.

The Law of Liabilities is a mirror image of the Law of Assets, arising out of the perfectlogical symmetry between assets and liabilities. Ignoring either Law is a serious breach ofsound accounting principles, possibly with grave consequences.

Consider the example of Japan, allowing the rate of interest to fall practically all theway to zero during a fifteen-year period. Present (in my opinion deeply flawed) accountingrules allowed companies and banks in Japan (including those banks that not so many yearsago were among the world’s ten largest) to understate their liabilities. Hence they could reportlosses as profits. Wholesale capital consumption and destruction was the result, withoutanybody realizing what was going on. Japan now has to live with a brain-dead bankingsystem operating on phantom capital. The economy has been brought to its knees spellingdeflation, depression, or worse, as indeed it seems to be happening right now. The cancer ofdepression has been metastasizing across the Pacific through the yen-carry trade, foolishlyencouraged by the F.R. and the Bank of Japan as a way to push interest rates even lower in theUnited States.

Rather than analyzing the Japanese example and drawing the appropriate conclusions,policy-makers in the U.S. had an irresistible itch to follow Japan’s jump into the abyss of theBlack Hole of zero interest. The result, perfectly predictable, is catastrophic. Yet the lessonhas not been learned: after successfully massaging the short end of the yield curve to zero, onMarch 18, 2009, the Fed announced that it has set out to massage the long end as well.

Historic failure to recognize the Law of Liabilities

Even if the fact were established that the Law of Liabilities has never been spelled out in anyaccounting code going back all the way to Luca Pacioli, we should still not jump to theconclusion that there is no justification for it. A convincing argument can be made explainingwhy the Law of Liabilities has escaped the notice of upright and knowledgeable accountantsin the past with the consequence that it has never been codified. Historically, rising rather thanfalling rates have been the rule in spite of the fact that, since time immemorial, the powersthat-be have shown a persistent bias favoring debtors at the expense of creditors, asdemonstrated by their efforts to suppress the rate of interest by hook or crook. However, thiseffort has been counter-productive. The usuriously high rates charged on loans in precapitalistictimes were not due to an alleged greed of the usurers. They were due to the usurylaws themselves. Charging and paying interest had been outlawed, but the result was notlower interest on loans as the authors of the usury laws had foolishly anticipated. On thecontrary, the result was rates higher than what the free market would have charged. Theexcess represented compensation for risks involved in doing an extra-legal businesstransaction.

Even though the usury laws were later repealed, other anti-business measures haveremained on the books that resulted in keeping interest rates higher than they would have beenin the absence of government interference. For these and other reasons, traditionally, theproblem was not falling but rising rates. In such an environment the Law of Liabilitiesremained inoperative and was easily overlooked. It is hard to discover a law that has beeninoperative through all previous history.

Revisionist history of the Great Depression

The picture changed drastically when the Fed started its illegal open market operations.

Thereafter falling rates became a regular feature of the landscape. Speculators were happy tojump on the bandwagon of risk-free profits. They could easily preempt the F.R. by purchasingthe bonds beforehand. After the F.R. banks have completed the purchase of their quotas,speculators could dump the bonds and pocket profits they have earned risk-free. The net resultwas a falling interest rate structure.

The undeniable fact is that the opportunity for risk-free profits from bond speculationdue to the introduction of open market operations was a major cause of the Great Depression.

It enabled bond speculators to siphon off wealth from the capital accounts of producerssurreptitiously. Yet to this day textbooks on economics hail open market operations as arefined tool in the hands of monetary authorities “to keep the economy on an even keel”. Onlyone other mistake economists have made does match this in enormity. Textbooks blame theGreat Depression on the “contractionist bias” of the gold standard. The truth is just theopposite. A second major cause of the Great Depression, in addition to the Fed’s illegal openmarket operations, was the government’s sabotaging of the gold standard in preparation for itsoverthrow, as I shall now explain.

The persistent fall of interest rates in the 1930’s has never been fully explained by theeconomists. They ignored the fact that the only competitor for government bonds, gold, hasbeen knocked out through confiscation, or the threat thereof, as well as other measures ofintimidation. In the absence of intimidation the marginal bondholder practices arbitragebetween the bond market and the gold market. He will sell his bond, a future good, and keepthe proceeds in gold, a present good, if the rate of interest falls below his time preference rate.

Conversely, if the rate of interest bounces back, he will buy back his bond at a profit. This isthe mechanism to regulate the rate of interest by time preference. Clearly, it breaks downwhen the gold standard is removed.

Indeed, when Britain (in 1931) and the United States (in 1933) left the gold standard,government bonds were freed from their only competitor. Bond values started to rise, makinginterest rates fall, causing prices to follow suit — as I shall explain below. The GreatDepression was self-inflicted. Governments in their zeal fired the policeman, the goldstandard, that was supposed to cordon off the Black Hole of zero interest to prevent interestrates from falling in. Speculators were quick to understand that this also meant the removal ofthe ceiling on bond prices. For the first time ever, there was an opportunity to bid bond pricessky-high. Speculators abandoned the high-risk commodity markets in droves and flocked tothe bond market to reap risk-free profits made available by the regime of open marketoperations. You cannot understand the Great Depression without understanding howspeculators reacted to the forcible removal of gold, the only competitor for government bonds,from the scene.

Thus the Great Depression had a dual cause: (1) the illegal introduction of openmarket purchases of government bonds by the Fed, and (2) the unconstitutional suspension ofthe metallic monetary standard by the government. Both measures worked to destabilizeinterest rates, more precisely, they both worked towards establishing a falling trend.

Paying out phantom profits

Superficial thinking may suggest that if the rise of interest rates is bad, then their fall is goodfor the economy. Not so. A falling rate is even more damaging than a rising one. I am awarethat my thesis is highly counter-intuitive. I have been challenged by many other economistswho deny the validity of my contention. They argue that if the present value of future incomeis lower when discounted at a higher rate, then it must be higher when discounted at a lower10rate of interest. We may admit that this statement is true. However, obviously, the firm has tobe around to collect the higher income. Many of them won’t be as they succumb to capitalsqueeze caused by the very falling of the rate that is supposed to be beneficial to them.

My critics hold that falling rates are always beneficial to business and it ispreposterous to suggest that they aggravate deflation. These critics confuse a falling structureof interest rates with a low but stable structure. While the latter is beneficial, the former islethal. When interest rates are falling, the low rates of today will look like high ratestomorrow. A prolonged fall creates a permanently high interest-rate environment. Thisparadox explains the reluctance of the mind to admit that falling rates spell deflation and, inan acute case, depression.

Falling rates mean that businesses have been financed at rates far too high and theycarry assets in the balance sheet at inflated values, due to their failure to revise depreciationquotas upwards. This fact of falling rates ought to be registered as a loss in the balance sheet,and ought to be compensated for by an injection of new capital. If businesses choose to ignorethe loss, and they merrily go on paying out phantom profits in the form of dividends andexecutive compensation, then they will further weaken their capital structure. When theyfinally plunge into bankruptcy, they wonder what has hit them. They don’t understand thatthey have failed to augment their capital in the wake of falling interest rates. Their downfall isdue to insufficient capital. In a falling interest rate environment all firms are affected by theelusive process of capital destruction. This was true in the 1930’s; it is still true today.

Incidentally, this also explains why American producers have been going out of business indroves since the mid-1980’s, resulting in the export of the best-paying industrial jobs to Asiancountries such as China and India where labor costs were lower.

The U.S. government is apparently unconcerned about the fact that the liquidationvalue of its debt is escalating by several orders of magnitude due to falling interest rates. Ithas increased a thousand-fold during the past 25 years, due to this one cause alone! This nonchalanceis explained by the fact that, after all, the Fed has the printing presses to createdollars with which any liability of the government can be liquidated, however large.

Cause: falling interest rates – effect: falling pricesAmerican producers are not so fortunate. They don’t have a printing press to make their debtburden lighter. They have to produce more and sell more if they don’t want to sink deeper indebt. But selling more may not be possible in a falling interest-rate environment except,perhaps, at fire-sale prices. What this shows is that the cause of deflation is not falling prices:it is falling interest rates. Falling prices is the effect.

Let’s spell it out how this mechanism works. As interest rates fall, a vicious spiral isset in motion. Lower rates send prices lower, and lower prices send rates lower still. Bondspeculators take advantage of the opportunity created by open market operations. They frontrunthe Fed in buying government bonds first. The resulting fall in interest rates bankruptproductive enterprise that could not extricate itself from the clutches of debt contracted earlierat higher rates. The debt becomes ever more onerous as its liquidation value escalates past theability to carry it. In addition, inadequate depreciation quotas undermine the financialstructure of all firms, as explained above. The squeeze on capital causes wholesalebankruptcies among the producers.

While they clearly have the power to put unlimited amounts of irredeemable currencyinto circulation, central banks have no power to make it flow in the “approved” direction.

Money, like water, refuses to flow uphill. In a deflation it will not flow to the commodity andreal estate markets to bid up prices there, as central bankers have hoped. Rather, it will flowdownhill, to the bond market, where the fun is, bidding up bond prices. As the central bank11has made bond speculation risk free, the bond market will act as a gigantic vacuum cleanersucking up dollars from every nook and cranny of the economy. The sense of scarcity ofmoney becomes pervasive.

In feeding ever more irredeemable currency to the money market the central bank cutsthe figure of a cat chasing his own tail. Contrary to the universal delusion that goes by thename “Quantity Theory of Money”, more fiat money pushes interest rates lower and fallinginterest rates squeeze producers more. They cut prices in desperation and cry out for thecreation of still more fiat money. To be sure, they get what they ask for. But their medicineturns out to be their poison. The creation of new money has a cost, namely, the F.R. banks’open market purchases of government bonds and the concomitant bull speculation in the bondmarket. Producers are squeezed further and are forced to make more price cuts. The viciousspiral is on.

The interest rate structure and the price level are linked. Subject to leads and lags, theykeep moving together in the same direction. Falling interest rates sooner or later induce fallingprices. This is the lesson from the revisionist theory of depressions, a lesson that has beenignored by economists.

Putting bank ratios in the vise

As the current global banking and credit crisis shows, destruction of capital was not confinedto the producing sector. Falling interest rates shrank bank capital across the board of thefinancial sector as well, without the shrinkage being detected. All banks were weakenedsimultaneously. They should have augmented their capital or should have reduced their assetspari passu with falling interest rates. They had done neither. In a mad pursuit of high leveragethey embarked upon a policy of increasing assets in the face of capital erosion. Bank ratioshave been put in the vise: they are squeezed on both sides. They are squeezed on the liabilityside because the liquidation value of liabilities stands to be revised upwards; but they are alsosqueezed on the asset side because the value of assets stands to be revised downwards.

At first, the banks thought they were making fabulous profits. It was only later that itdawned upon them that, in fact, what they were paying out in the form of dividends andcompensation were phantom profits. This compounded the problem of capital erosion. By2008 the banks have reached the stage, more or less simultaneously, where all of their capitalwas wiped out. The credit crisis burst upon the scene with elemental force.

Through its open market operations the F.R. has, unwittingly, generated a deflationaryspiral that ultimately bankrupted not just the producing sector, but the financial sector as well.

Like the Sorcerer’s Apprentice, the F.R. started the march to the Black Hole of zero interest,but did not have a clue how to stop it when the pull of the Black Hole has become irresistible.

At that point the deflationary spiral got out of control.

The onset of Great Depression

It is nothing short of frightening to see how policy-makers in the U.S. have misread andmisinterpreted the danger signals warning of an imminent collapse of the financial system andthe economy, and how they continue to prescribe the wrong medicine. We must face the factthat the present crisis is far worse than that of 1929. For one thing, the economy is so muchlarger making the collapse more damaging. Even more serious is the increasing debt burdenthat the collapsing economy is no longer able to carry.

The credit of the United States was incomparably stronger in 1929. Eighty years agothis country was the largest creditor in the world, a position it was to keep for the next fortyyears. By now the U.S. is the largest debtor nation in the world that needs to borrow money to12pay interest on its debt. The tipping point was the year 1971 when the dollar was formallymade an irredeemable currency. During the last forty years a colossal dissipation of wealth,unprecedented in history, has taken place. It was mostly unseen since it was papered over byan artificially fed boom in consumption. It is altogether futile to expect that the Americanconsumer will pull up the world economy with his renewed spending if given the necessarypump-priming followed by sufficient stimulus.

Today the greatest creditor nation in the world is China. Is it realistic to expect that theChinese consumer will take over the role traditionally played by the American consumer,given the fact that his government is a prisoner of Communist ideology?We are still far from the trough of this depression, officially labeled a ‘recession’. Atthe trough the devastation will be far greater than that experienced in 1932, if for no otherreason that there was no derivatives tower then, whereas we have one now that threatens theworld with toppling. Only the tip of the derivatives iceberg has been identified by the captainof this ‘unsinkable’ Titanic, but not the invisible submerged part. He is oblivious of the factthat the inevitable collision will take place at greater depths.

Worst of all is the blockheadedness of policy-makers as they desperately stick to theirlong-since discredited Keynesian nostrums. Every measure they propose is counterproductive.

They seem to be unaware of the truism that pump-priming is useless if there is no water in thewell. Likewise, there is no point in stimulating an organism that suffers from blood poisoning.

One has to treat the disease first. In this case blood poisoning is caused by irredeemablecurrency that hasn’t got the prerequisite quality to act as the ultimate extinguisher of debt. Asa result, the world suffers from “debt poisoning”. Thus the problem is to remove the cause ofpoisoning, irredeemable currency, from the system, before any other therapy can be madeeffective.

How to stop Great Depression II?

We have to stop the march to the Black Hole of zero interest. Restoring sound accountingstandards is imperative. It is most unfortunate that the first tentative step in this direction, thecompulsory marking of bank assets to market, will probably be rescinded as the authoritiescave in to the vicious agitation of the bankers. Observers still have their blinkers on andcannot see the capital destruction caused by the failure to carry liabilities in the balance sheetat liquidation value. We must stop turning a blind eye to the deleterious effect of a fallinginterest rate environment on capital deployed in support of production. Open marketoperations of the F.R. must be outlawed and risk-free speculation in bonds stopped. Theyhave been the chief cause of deflation as demonstrated by the pull of the Black Hole of zerointerest.

The gold standard must be rehabilitated in order to abolish the inadmissible monopolyof government bonds. Some say this is unlikely to happen because it would be too painful.

However painful, the alternative is many times more painful. The alternative spells a totalbreakdown of law and order due to unacceptable levels of unemployment, much worse thanthat experienced in the 1930’s. The unraveling of social fabric threatens the survival of ourrepublic and our civilization.

Self-liquidating credit has not been used since the outbreak of World War I. Bills ofexchange with short maturity, payable in gold, drawn on fast-moving consumer goods in highdemand, should be reintroduced as the means of financing multilateral world trade inpreference to bilateral.

The key is in the hand of the U.S. government. It is the same key that was used to lockthe U.S. Mint to silver in 1873, and to gold sixty years later, in 1933. By using it now to open13the U.S. Mint to both silver and gold, the U.S. government can effectively cordon off theBlack Hole of zero interest to prevent further damage.

At stake is nothing less than the question whether America can reclaim control over itsdestiny, saving Western Civilization in the process.

Antal E. Fekete

San Francisco School of Economics

aefekete@hotmail.com

Read all the other articles written by Antal E. Fekete 

DISCLAIMER AND CONFLICTS
THE PUBLICATION OF THIS LETTER IS FOR YOUR INFORMATION AND AMUSEMENT ONLY. THE AUTHOR IS NOT SOLICITING ANY ACTION BASED UPON IT, NOR IS HE SUGGESTING THAT IT REPRESENTS, UNDER ANY CIRCUMSTANCES, A RECOMMENDATION TO BUY OR SELL ANY SECURITY. THE CONTENT OF THIS LETTER IS DERIVED FROM INFORMATION AND SOURCES BELIEVED TO BE RELIABLE, BUT THE AUTHOR MAKES NO REPRESENTATION THAT IT IS COMPLETE OR ERROR-FREE, AND IT SHOULD NOT BE RELIED UPON AS SUCH. IT IS TO BE TAKEN AS THE AUTHORS OPINION AS SHAPED BY HIS EXPERIENCE, RATHER THAN A STATEMENT OF FACTS. THE AUTHOR MAY HAVE INVESTMENT POSITIONS, LONG OR SHORT, IN ANY SECURITIES MENTIONED, WHICH MAY BE CHANGED AT ANY TIME FOR ANY REASON.

Copyright © 2002-2008 by Antal E. Fekete - All rights reserved