The Great Deformation

by David Stockman

  So FDR’s approach to countercyclical management of the domestic economy by means of the Fisher compensated dollar strategy was largely a fizzle. The January 1934 reduction of the dollar’s gold content by 40 percent (to $35 per ounce) was supposed to catalyze a further energetic rise in the wholesale prices, but it never happened. The wholesale price index, which had recovered substantially before FDR took office, then stood at 80 and simply flat-lined around that level for years; it was still at just 77 when the US economy was about to shift to a war footing in mid-1939.

  In short, the peacetime New Deal did embrace a form of countercyclical policy, but it was Fisher’s reflation rather than the deficit finance of Keynes. Nevertheless, at the end of the day the nation’s fiscal demise was enabled by the Thomas Amendment’s destruction of the gold dollar. Now it was only a matter of time before Professor Friedman would provide Richard Nixon with the rationale to finish the job FDR had started.

  GOLD REVALORIZATION AND THE

  WHITE HOUSE SLUSH FUND

  The one thing that FDR raised with his Fisherite levitations was a White House slush fund called the Exchange Stabilization Fund (ESF). At the stroke of FDR’s pen, the price of gold went from $20.67 per ounce to $35, thereby causing the value of the nation’s gold stock to rise from $4.2 billion to $7 billion.

  Most of this $2.8 billion “revalorization” gain was assigned to the newly created ESF. Under the terms of the Thomas Amendment the fund was available for such purposes as the president directed. During the remainder of the peacetime 1930s, therefore, Secretary of the Treasury Morgenthau became a virtual monetary czar. This dominance was facilitated by the fact that the nation’s actual central bank, the Federal Reserve, was near dormant. The reason for the Fed’s irrelevance was not hard to fathom. By 1934–1935 the domestic banking system was becoming saturated with idle cash, reflecting negligible demand for loans from the somnolent US economy.

  Indeed, the striking evidence that cash was king lies in the buildup of excess bank reserves parked at the Fed. These soared from $2.7 billion in 1933 to $11.7 billion by 1939, and accounted for 75 percent of the Fed’s balance sheet growth during the period.

  All this money resulted in short-term interest rates which were persistently below 1 percent after 1934. Indeed, there was never any monetary stringency during the 1930s that the Fed failed to alleviate. On the contrary, the record shows conclusively that in the midst of sustained debt liquidation, increases in bank reserves result merely in “pushing on a string,” not credit expansion and economic stimulus.

  Ironically, the Fed today is generating excess bank reserves in an identical manner to what occurred during the mid-1930s, and with the same lack of effect. Bernanke’s reputation as an expert on monetary policy during the Great Depression is thus wholly undeserved: he is pushing on the same string that the great Fed chairman of the day, Marriner Eccles, knew to be incapable of fostering recovery.

  To be sure, the massive growth of excess domestic bank reserves during the mid-1930s was due to large-scale inflows of gold from abroad rather than Federal Reserve money printing. Yet that is merely a technical difference. Bank reserves could come from either source. Yet under the prevailing cycle of debt deflation, neither source of bank reserves resulted in a single extra solvent customer for loans.

  FDR’S BALEFUL LEGACY: STATE MONEY WHICH ENABLED PERMANENT FISCAL DEFICITS

  As the war clouds gathered in Europe, the United States increasingly became a safe haven. Consequently, the nation’s official gold reserves doubled from $10 billion to $20 billion during the second half of the decade and reached two-thirds of total global gold reserves. This gold inflow brought persistent upward pressure on the dollar’s exchange value, inducing the Treasury Department to intervene chronically in foreign exchange markets, using its ESF slush fund to do so. Consistent with its Fisherite monetary views, the aim of this White House currency market intervention was mainly to prop up the franc and pound sterling and weaken the dollar.

  And so went the string of New Deal monetary policy actions which began with the April 6, 1933, confiscation of private gold. The thread was extended through FDR’s embrace of the Thomas Amendment, the London bombshell letter, the breakfast-time gold buying with Professor Warren, the 1934 revalorization of the gold price, and these ESF’s foreign exchange market interventions.

  When all was said and done, these actions had congealed into a historic policy departure; that is, the nationalization of money. Henceforth, the nation’s money would become a subordinated tool of the state’s domestic stabilization policies. No longer would money occupy its historic role as a private instrument of commercial exchange and storehouse of value, redeemable for an asset whose price was fixed, intrinsic, and derived wholly apart from the state.

  At the end of the day, this was the true New Deal break from the past and from what had earlier been Herbert Hoover’s last stand for financial orthodoxy. To his credit, Hoover had never wavered from the gold standard, even as he had succumbed to a variety of dubious expedients such as the RFC bank bailouts, meddling in corporate wage and price setting, and the abomination of the Smoot-Hawley tariff.

  The far-reaching implications of the New Deal’s radical monetary policies have not been highlighted by contemporary analysts because they did not involve aggressive money printing by the Fed. But they amounted to the same thing. Owing to the weak economy and strong gold inflow, money market conditions were intrinsically easy, at least by the standards of the day. After 1934, commercial paper and T-bill rates were thus stuck under 0.5 percent, long-term government bonds yielded 2.5 percent, blue chip corporate debt yielded 3.5 percent, and cash was superabundant.

  Under those conditions the Fed knew better than to “push on a string,” and had not yet even dreamed of employing open market operations as a tool of plenary macroeconomic management. Indeed, the Fed’s paramount leader after 1934, Chairman Marriner Eccles, was a fiscalist who spent most of his time preaching to the White House about the need for more deficit spending, not easier money.

  Still, Irving Fisher’s “managed currency” theories, as embodied in the New Deal’s monetary tinkering, established the crucial predicate; namely, that monetary manipulation is a legitimate tool of state policy. So doing, it paved the way for latter-day management of the gross domestic product (GDP) by means of Keynesian deficit spending and Greenspan-Bernanke-style monetary central planning.

  The truth is, Keynesian policy was a nonstarter under the old régime of gold-convertible money. Fiscal deficits could be body checked at any time by the people themselves, who had the right to dump their paper money for gold whenever they lost confidence in the fiscal discipline of the state.

  Thus, Fisher’s “compensated dollar” undoubtedly sounds quaint to modern ears. Yet it was the crucial way station to the new world of permanent deficit spending and the T-bill standard money which was eventually to come.

  KEYNESIANISM IN ONE COUNTRY: THE GREAT THINKER’S CASE FOR HOMESPUN GOODS AND MONEY

  The New Deal also established a supplementary predicate which was equally crucial to an embrace of thorough-going Keynesian macro-management: Namely, the essentially protectionist notion of a closed domestic economy and the subordination of the rules with respect to international movement of goods, capital and money to the dictates of domestic policy. That predicate was the essence of FDR’s London bombshell.

  It was on the matter of autarky—America first—that the New Deal fell in line with Keynes’ true contribution to the depression era policy debate. Indeed, the inspiration for the New Deal was never really the erudite ramblings of the 1936 “General Theory.” Instead, it was the rank protectionism of Keynes’ 1933 essay entitled “National Self-Sufficiency.”

  In the latter treatise, the great thinker averred that art, hospitality and travel might properly remain in the sphere of internationalization. But as to the core matter of economics—the movement of merchandise goods and financial capital—the time had come, as Keynes saw it
, to roll-back the clock.

  The prior 300 years of western progress by nearly every account had been based on international trade and comparative advantage, but Keynes had no compunction about pronouncing Adam Smith wrong. Based on an apparent flash of revelation that had been absent from his writings of even a few years earlier, Keynes now urged for an era of national autarky.

  Operating behind moats at the border, the state would thus mobilize and command domestic economic life without interference: “I sympathize, therefore, with those who would minimize…economic entanglements between the nations…let goods be homespun whenever it is reasonably and conveniently possible; and, above all, let finance be primarily national.”

  Keynes fancied himself a dandy, of course, and would never have been caught wearing homespun attire from the equivalent of Gandhi’s loom. But when it came to entire nations and their unwashed masses, it is not at all surprising that he thought that nationalistic and autarkic Nazi Germany was the most likely candidate for early adoption of his program. He even took personal care to insure that his works were always available in German.

  Perhaps Keynes’ newfound distain for international commerce was colored by his experience as a currency speculator during the 1920s when he had repeatedly made bets on the whims of national policy-makers. The topic of Keynes’ currency bets was always the same—that is, when and at what parities would various countries—including Great Britain—“resume” convertibility and fixed exchange rates.

  Indeed, the trials and tribulations of France, the Belgium, Italy and others during their postwar quest for “resumption” of currency convertibility embodied an unassailable lesson that Keynes had surely grasped. The scope for domestic fiscal policy action and macroeconomic management became sharply constrained when nations embraced honest, gold-redeemable international money.

  So during the prolonged debate over British resumption, Keynes became a shrill opponent of the gold standard and the idea of international money as the world had previously known it. The vainglorious professor from Cambridge had thus arrived at the conclusion that “Keynesianism in one country” was the wave of the future and that his nostrums required an essentially closed economy and national fiat money.

  In this sense, Roosevelt was the tribune who made Keynesianism possible. By his obdurate rejection of the advice of his internationalist advisors—Lewis, Warburg, Hull, Glass—FDR smothered the last impulse to resurrect a liberal world economic order and valid international money. Roosevelt the Fisherite thus made full strength Keynesianism ultimately possible.

  To be sure, having shed the shackles of international monetary discipline, the New Deal didn’t really know what to do with its new found freedom of action. As has been seen, many of the New Deal’s hallmark legislative enactments—the NRA, AAA, the Wagner Act and the Fair Labor Standards Act—were exercises in economic restriction rather than Keynesian demand expansion.

  HENRY MORGENTHAU’S LAST STAND FOR BUDGET ORTHODOXY: WHY US FISCAL BANKRUPTCY TOOK TIME

  The irony of the New Deal is thus striking. Even when there was virtually no monetary check on deficit spending, it did not go all-out for Keynesian stimulus owing to a vestigial state of mind; that is, an inculcated belief in balanced budget orthodoxy.

  Adherence to the old-time fiscal religion by policy makers was a crucial rearguard force which retarded the adoption of Keynesian policies during the initial four decades after the New Deal. Indeed, in a double dose of irony, it was the abandonment of balanced budget orthodoxy by the GOP after 1980 that led to the nation’s rapid fiscal demise thereafter. Yet this eventuality was latent the day FDR embraced the Thomas Amendment and the end of sound money.

  As it happened, the principle agent of fiscal orthodoxy in FDR’s inner circle was Treasury Secretary Henry Morgenthau. Morgenthau was second only to FDR himself in his ardor for Professor Fisher’s radical monetary doctrine of the compensated dollar, but like so many subsequent policy makers of the interwar generation, Morgenthau kept his fiscal and monetary doctrines compartmentalized.

  Time and time again Morgenthau fought to restrain New Deal spending and deficits. His famous diary is literally chockablock with expressions of fiscal rectitude, yet the fiat dollar régime he so enthusiastically embraced would have permitted deficits of a scale that would have pleased even Larry Summers.

  By the eve of World War II, an exhausted Morgenthau penned an entry expressing a complete lack of faith in deficit spending: “We have tried spending money. We are spending more than we have ever spent before and it does not work … I say after eight years of this administration that we have just as much unemployment as when we started…. And an enormous debt to boot.”

  The fiscal trends which alarmed Treasury Secretary Morgenthau, however, turned out to be worrisome only by the chaste standards of the past. During FDR’s six peacetime budgets (1934–1939), federal spending never reached even 10 percent of the national economy and the fiscal deficit averaged just 3.9 percent of GDP. And that was during the greatest depression in world history.

  American politicians thereafter gradually learned that the ancient discipline of honest money had been lifted, so they steadily pushed out the fiscal boundaries. The fiscal deficit during 1975–1980, for example, averaged 3 percent of GDP and then raced past the New Deal record to an average deficit of 4.3 percent of GDP during the Reagan Administration. And this was during an eight-year span which included six years of “morning in America.” Accordingly, the way was paved for the fiscal lunacy of the George W. Bush era and the explosive last gasp of Keynesianism under Obama.

  As the curtain closed on the 1930s, Morgenthau’s doctrinal contradiction was just the most exaggerated case of the split-screen attitude of the New Deal’s conservative wing. Many of the stalwart southern Democrats who were critical to the Roosevelt coalition—such as Vice-President John Nance Garner, RFC head Jesse Jones, Senator Jimmy Byrnes of South Carolina, and Senator Walter George of Georgia—had generally welcomed soft money and dollar depreciation, even as they remained wary of fiscal deficits.

  Eventually, however, the fiscal orthodoxy which had been part and parcel of the gold standard world faded away as its adherents like Morgenthau and the conservative southern Democrats left the scene. Still, even as they went through the motions of their rearguard battle against deficits, the destructive fiscal legacy of the New Deal was just getting started.

  The seeds of crony capitalism had been planted in the farm belt and among crippled economic sectors like the railroads and the merchant marine. The ticking fiscal time bomb of social insurance had been institutionalized, even as a régime of industrial union monopoly cast a long shadow on the national economy’s ability to shoulder the cost burden.

  Likewise, the federal agencies which would fuel the housing mania had been chartered, and only a frail regulatory harness on the banks held the vast moral hazard of deposit insurance temporarily in check. Most important of all, FDR’s final destruction of the gold standard had paved the way for open-ended statist intervention and hyperactive management of the domestic economy.

  This misguided and fiscally cancerous project would soon be embraced by both parties. It was a development which was bound to end in the triumph of crony capitalism and the fiscal bankruptcy of the nation.

  CHAPTER 10

  WAR FINANCE AND THE

  TWILIGHT OF SOUND MONEY

  THE NEW DEAL’S AD HOC STATISM WAS EVENTUALLY SUPERSEDED by the real thing: the full-bore warfare state spawned by the Japanese attack on Pearl Harbor. Under the exigencies of total war, all of the tools of modern fiscal expansion and monetary manipulation were discovered, tested, amended, and perfected.

  But when the peace came in 1945, the victory of these warfare state–inspired policy tools was neither complete nor immediate. Indeed, over the next quarter century the canons of financial orthodoxy found intermittent, and sometimes poignant, expression under Presidents Harry Truman and Dwight D. Eisenhower, and the long-reigning Fed chairman William
Mc-Chesney Martin. Even President John F. Kennedy kept orthodoxy alive, at least in the Treasury Department and its international dollar policies.

  So the road from Pearl Harbor to Richard Nixon’s decision to default on the nation’s Bretton Woods obligation to redeem its debts in gold, eventually ushering in printing-press money and giant fiscal deficits, is important to retrace. In the interim there occurred episodes of fiscal and monetary discipline that have long since been purged from mainstream memory. Yet these were signal moments of inspired governance which underscore just how much was lost with the waning of the old-time financial orthodoxy.

  One was President Harry Truman’s insistence on financing the Korean War the honest way, with higher current taxes. Another was Eisenhower’s refusal to adopt tax-cut stimulus during the two recessions on his watch, thereby enabling him to achieve his highest fiscal priority: balancing the federal budget.

  Still another shining moment came in August 1958 when Fed chairman William McChesney Martin moved to “take away the punch bowl” in order to discourage stock market speculation only four months after the economic recovery had begun. And rarely noted is that President Kennedy’s first economic policy address was a ringing commitment to maintain the nation’s Bretton Woods obligations and to defend the gold dollar.

  It is entirely accurate and warranted to say that Nixon’s embrace of Professor Friedman’s floating paper dollar was the fatal turning point which brought a final end to sound money. Yet what the road to August 1971 also demonstrates is that Tricky Dick’s abomination was not inevitable. There was, in fact, a twilight of sound money along the way.

  WAR FINANCE AND THE RISE OF THE FED’S OPEN MARKET BOND AND BILL BUYING

  Once war was declared, the Roosevelt administration dusted off the techniques discovered during the Great War mobilization of 1917–1918 and soon imposed a complete command-and-control régime that reached into every nook and cranny of the American economy. The steel, auto, metal-working, machinery, and other heavy industries were commandeered to make ships, planes, and tanks. Production of housing, autos, household durables, and other discretionary items was eliminated almost entirely.