Roosevelt stopped loan contraction with his monumental April 1933 decision to discontinue private ownership of gold. Many have characterized this as Roosevelt “taking the United States off the gold standard,” but what he did was somewhat different. His Executive Order 6102 prohibited “the hoarding of gold coin, gold bullion, and gold certificates within the continental United States by individuals, partnerships, associations, and corporations.”
Roosevelt’s order required that on or before May 1, 1933, all persons deliver to a Federal Reserve Bank or member bank all their gold coin, gold bullion, and gold certificates (those more than a hundred dollars per person) except as may be required for industry. The Federal Reserve would pay $20.67 per ounce in coin or currency. “Two months later, a joint resolution of Congress abrogated the gold clauses in many public and private obligations that required the debtor to repay the creditor in gold dollars of the same weight and fineness as those borrowed.”36
This immediately and dramatically reversed the outflow of the previous three years. Instead of people withdrawing deposits from banks or using currency to buy and hoard gold, they were required to deposit all their gold. With this, the contraction of deposits ended—which in turn brought an end to the contraction of loans, just as changes in gold policy in Germany and Britain two years earlier had brought an end to the contraction of loans in those two countries.
The executive order immediately brought hundreds of millions of dollars of deposits back into the banking system as Americans compliantly deposited their gold, reversing the outflow and contraction that had begun in earnest in 1930. In 1934, in a bold act of fiat, the United States increased the price of gold from twenty to thirty-five dollars per ounce, which immediately revalued gold upward by billions of dollars—directly increasing the money supply.37 (This was a devaluation of the dollar.) In the years following the increase in price to thirty-five dollars, billions of dollars of additional gold and accompanying deposits flooded into the system. The contraction problem had been solved.
In 1932, gold and gold certificates at the Fed had been $3.1 billion ($4.2 billion, if we include all gold held by the Treasury and private citizens). The revaluation alone took that amount to more than $5 billion, and by 1938 the total was $11.8 billion ($14.5 billion for the country as a whole). Bank deposits at the Fed, by definition, tracked that closely, increasing from $2.5 billion in 1932 to $8.7 billion in 1938. Much of that gold came from overseas, pulled by the favorable price and pushed by the gathering storms of war. The result was a large amount of new deposits in the United States, some of which would inevitably be spent here. The largest portion of the world’s gold was now in the United States.
In contemporary banking, the Federal Reserve injects money into the system by buying government securities from banks. In the 1930s, its approach was different. The Fed increased deposits and thus the money supply by man-dating that gold out in the economy be deposited to banks and then the Fed, and then it sweetened the equation with a substantially higher price.
Roosevelt also created the Federal Deposit Insurance Corporation (FDIC) in the Banking Act of 1933, and with it, deposit insurance. The government would now guarantee deposits even if a bank failed, which removed the rationale for individuals to withdraw their money from banks. It should be noted, however, that other major countries, such as Britain, France, and Germany, did not enact deposit insurance, and their recoveries did not suffer in comparison. In those countries, the change in gold policy alone was sufficient to reverse the contraction of deposits. (See the relevant month-by-month figures in the Crisis Recovery Worksheet at www.bankingcrisis.org.)
The contraction was stopped, so the recovery could begin. But that did not get banks (or any other private lender) to start growing loan portfolios again. There was simply too much overcapacity and therefore no need for loans. Once an economy is massively overbuilt, only time can bring enough new demand to absorb that overcapacity. By 1929, it was going to take years and even decades for the real estate overcapacity to be fully absorbed. And once lenders had made the ill-advised loans that resulted in overbuilding, it was going to take years to work out those bad loans—and it was going to take billions of Depression-era dollars to recapitalize the banking industry. The fact that bank loan contraction had damaged thousands upon thousands of good businesses made the climb out of the Depression that much harder.
Absent loan growth, the major boost to GDP was the continued increase in government deficit spending, reflected in the $10 billion increase in government debt during this time. Additional growth came as households took savings from “under the mattress” and into a less cautious spending pattern. Unemployment also gradually improved after FDR’s arrival, stepping down to 13 percent in 1937 (until an ill-advised pullback in government spending and a tax increase dented the still-fragile recovery, and unemployment rocketed back to 18 percent). Nothing came easily. The Dust Bowl drought that struck farmers intermittently from 1934 to 1940 was just one of many challenges.
In the end, the increased economic activity surrounding World War II boosted the country all the way out of the Depression. This was not an unprecedented salve. The recovery from earlier U.S. depressions had been much aided by such things as the onset of war and its expenditures.
Unnoticed by many, the combination of the Great Depression and World War II also facilitated a great deleveraging in the private sector. The Great Depression brought the ratio of private debt to GDP down from 175 percent in 1930 to 126 percent by 1940, then the war took it down again to a century-low level of 37 percent by 1945. We might call this fifteen-year period the Great Deleveraging. The path to achieve it had been brutal, but it ideally positioned the private sector for the high postwar growth that was indispensable for the federal government to deleverage. Resulting private debt levels were so low that a financial crisis was significantly less likely for several decades.
Figure 1.9. 1928 Gross Domestic Product by Country
In smaller industrialized economies throughout the world, a similar plot-line of leverage boom, bust, and recovery unfolded. From the standpoint of sheer size and impact, the history of the Great Depression outside of the United States is primarily the history of Germany, Britain, and France. The GDP of the United States was larger than the GDP of those three countries combined, and their GDP in turn was collectively larger than that of the rest of Europe combined. Of all the countries outside the United States, Germany was the worst economic offender, with its profligate lending creating a major expansion followed by a major GDP collapse.
Germany, after emerging from the hyperinflation of the early 1920s, saw runaway private lending growth, with aggregate bank loans alone more than tripling from 8 percent to 31 percent of GDP in the 1920s (data on bond and other nonbank debt are not available). France had a strong expansion too, with GDP growth averaging 14 percent from 1923 to 1928, and bank loans doubling from 15 percent to 27 percent of GDP; its heady times were called années folles, or the crazy years. Britain did not enjoy the fully robust 1920s that its industrial neighbors did, in large part because just as the good times began, Britain administered a self-inflicted wound. In 1925 Winston Churchill, whether owing to false national pride or misguided economic beliefs, put Britain back on the gold standard it had left during World War I. Its lending surge was offset by the contraction of the restored gold standard.
Table 1.2. Germany Crisis Matrix: 1920s and 1930s
*Limited data points.
From 1925 to 1930, Germany’s bank loans increased over fivefold, and mortgages increased almost ninefold.
In the bust phase, Germany’s GDP fell from 81 billion marks in 1929 to 51 billion in 1932, a drop of 37 percent in nominal terms, nearly as steep a drop as in the United States. The stock market fell by 45 percent. Unemployment rose to an astonishing 29 percent. This new economic calamity was the perfect platform for the great electoral gains of the Nazi party in 1932 and Hitler’s appointment as chancellor in 1933. France’s GDP dropped by a stu
nning 42 percent before beginning to recover. Having not climbed as high, Britain did not sink as low, although it did experience 15 percent unemployment.
For Japan, the 1920s were a turbulent decade, with recurring trouble, culminating with a GDP drop in 1927, and a bigger drop in 1930, both following an outsized expansion of lending in the mid-1920s. As in the United States, real estate, both residential and commercial, was the dominant sector that spun into a bubble, including the new urban housing developments that came alongside train stations and electrical plants, as well as heightened investment in rice paddies. This situation quickly evolved into speculation and land fever. During the 1920s, the price of takuchi (nonagricultural) land in Osaka “grew at annual rates of over 25 percent,” rising to more than 30 percent in the late 1920s.38 According to Takashi Nanjo, land prices had slumped to 74 percent by 1929.39
Private debt was a core cause of the Great Depression and, as the rest of this book will show, of most other major financial crises. Many economists have argued that a combination of several factors caused the Great Depression and other major financial crises. This is not an unreasonable suggestion. For example, the economic historian Charles Kindleberger noted no less than thirteen factors in the crash of 1873.40 But long lists of reasons hint at explanatory scrambling and belie the fact that in every economic period, even in good times, there are always a number of adverse factors at work. Economists must also be able to make a plausible financial case for causality and the weighting of each item on the list.
And lists of many complex factors introduce causal obfuscation where there is causal elegance to be found: overlending is the necessary and sufficient explanation for a majority of financial crises, whether or not other possible causes are present. While the presence of a large net export position can help mitigate the problems brought by high private debt growth, no other factors—even in combination—yield the same close correlation and powerful result as private debt growth. Nor do they add to or change the power of models used to predict financial crises.
In some key respects, the Great Depression was similar to the 2008 crisis in the United States. In both crises, mortgages and other real estate lending soared as lenders lowered credit standards. In both, overbuilding peaked two to three years before the crisis, and by that point, bad loans associated with the overbuilding had already made widespread lender failures inevitable. And in both, most participants were blithely unaware of the problem until the stock market crash and property value collapse.
The critical difference between these two crises was the willingness of the government to intervene to save certain banks and other financial institutions from failure and thus save at least some of the innocent from calamity. This was a lesson from the Great Depression—that the government should act in a crisis to prevent banks from failing and thus prevent loans from contracting.
Figure 1.10. Deposits of Failed and Assisted Banks as a Percentage of Total Deposits
Figure 1.10 illustrates this. The number of bank failures in the Depression dwarfed those in the Great Recession. However, if we consider the total deposits of those institutions that were “assisted,” or rescued, the bank distress in the Great Recession tops that of the Great Depression. With these rescues, the Fed essentially played its “lender (and investor) of last resort” role. Issues of fairness aside, if those institutions had not been rescued, the period after the Great Recession might have looked more like the 1930s.
With this Great Depression lesson in hand, Japan’s crisis of the 1990s and the Global Crisis of 2008, which both had similar relative magnitudes of overbuilding and bad debt creation as the Great Depression, had much less severe aftermaths. This approach had the benefit of preventing the mass unemployment and the Hoovervilles of the Great Depression, but it would have left in place a giant overhang of private debt. In contrast, as terrible as it was, the United States emerged from the Great Depression with very low levels of private debt, which was an advantageous position from which to power renewed growth. Both Japan after its 1990s crisis and the United States after its Great Recession were still carrying very high loads of private debt that burdened their economies and dampened growth for a number of years.
Our next chapters will cover the great crises of the 1980s and 1990s in the United States, Japan, and beyond—the moment when the great global deleveraging that followed World War II turned into a great global releveraging.
CHAPTER 2
The Decade of Greed
The 1980s
Many remember the 1980s as a renaissance in the United States. Newly elected president Ronald Reagan and Federal Reserve chair Paul Volcker were credited with defeating the inflation of the 1970s. Real GDP growth averaged 3.3 percent. Unemployment declined to less than 6 percent, and the stock and bond market ended the decade up 228 percent and 253 percent, respectively.
Yet those memories belie stark realities of calamities and crises. The decade of the 1980s was one of the most economically turbulent and crisis laden in American history. Indeed, it was perhaps the most chaotic in terms of the number of sectors adversely affected. The results of the period led to more than two thousand bank failures, more than eight hundred savings-and-loan failures, the junk-bond crisis, the commercial real estate crisis, the Latin American debt crisis, and an energy-lending crisis triggered by an oil price collapse. There was even an agricultural lending crisis early in the decade. In each one of these, it was a rapid buildup in private debt that brought the overcapacity and crisis. This decade saw the largest wave of bank failures since the 1930s. And it saw the largest percentage one-day stock market drop in U.S. history, on October 19, 1987, a collapse parried only when the Federal Reserve flooded the market with unprecedented levels of liquidity.
Even the achievements of the 1980s should be put in context. The stock market ended up rising 228 percent, but that was less than the gains of the 1960s and 1990s. Real GDP growth was 3.3 percent, but growth in the 1960s, 1970s, and 1990s was just as high, if not higher. Unemployment improved but had been lower in the 1960s and early 1970s, and was again lower in the late 1990s.
Reflections on this period routinely miss what, economically speaking, was its most important characteristic: the 1980s saw an unprecedented explosion of both government and private debt. This was all the more notable in that it followed thirty years of a significantly improving ratio of federal debt to GDP and flat overall growth in total debt to GDP (Figure 2.2).
Figure 2.1. United States: Total Bank Failures, 1935–1995
Indeed, the year 1981 may be the greatest economic dividing line of the post–World War II era, a watershed in U.S. economic history: it was the moment when the era of postwar deleveraging ended and the era of releveraging began—complete with a quickly ensuing financial crisis. This dividing line also marked the point at which, not coincidentally, U.S. rates ceased their long postwar rise and began their equally long decline.
The very low level of U.S. private sector debt in 1945—it was less than half the level in ratio to GDP seen earlier in the century—was a noteworthy exception in twentieth-century economic history. It was not just private debt that was low in the immediate postwar period. The United States had low levels in housing, commercial real estate, infrastructure, and any number of other things, a state of undercapacity made more acute by a population boom. This, coupled with the record low levels of private debt, were key reasons that the United States had no notable nationwide financial crisis from 1950 to 1980.
But, as measured by total debt to GDP, the United States started releveraging in 1981. In fact, in the brief period from 1983 to 1988, private debt to GDP expanded from 103 percent to 124 percent of GDP1—one of the largest such increases in the twentieth century. Mortgage loan growth was the biggest part of this, almost doubling from $1.1 trillion to $2.1 trillion.2 Though the impact of this rising total on households was offset somewhat by declining rates (from a high of 18.45 percent in 1981 to 10 percent by 1987), it brought a sharp increase in delinquenc
y and foreclosure rates, along with a pronounced spike in mortgage industry losses in the early 1990s. Commercial real estate loan growth was the next most pronounced, almost doubling from $551 billion to $1 trillion.3
Figure 2.2. United States: Debt as a Percentage of GDP and Long-Term Interest Rates (10-Year T-Bill Yield), 1950–2017
Left axis scale for all but 10-year T-Bill.
The third biggest loan growth contributor was manufacturing, which also nearly doubled its leverage from $543 billion to $1.07 trillion.4 This era of manufacturing debt growth left industry vulnerable to the imminent onslaught of global manufacturing competition. Junk bonds, the riskiest form of corporate debt, were a major subset of private debt, more than quintupling from $30 billion to $160 billion.5 There were also large spikes in loans for oil and gas, for agriculture, and to Latin American countries, each of which led to a crisis within its respective sector.
Government debt, which had actually declined slightly as a percentage of GDP in the 1970s, from 34 percent to 31 percent, thundered ahead to 50 percent during the 1980s.6 Throughout the century, most problematic debt expansions were either composed of private debt or public debt, but not both, and usually one offset the other. Not in the Reagan era. His tenure saw much of both, si mul ta neously, as he led rec ord government and military spending. It was stimulus on steroids.
Table 2.1. U.S. Crisis Matrix: 1980s and 1990s
In the five years leading to 1988, U.S. private debt grew by 73 percent. Sectors with the greatest concentration of overlending were mortgage, manufacturing, and commercial real estate, which together comprised 72 percent of the increase.
A Brief History of Doom Page 6