FRIEDMAN’S ERRONEOUS CRITIQUE OF THE DEPRESSION-ERA FED OPENED THE DOOR TO MONETARY CENTRAL PLANNING
The historical truth is that the Fed’s core mission of that era, to rediscount bank loan paper, had been carried out consistently, effectively, and fully by the twelve Federal Reserve banks during the crucial forty-five months between the October 1929 stock market crash and FDR’s inauguration in March 1933. And the documented lack of member bank demand for discount window borrowings was not because the Fed had charged a punishingly high interest rate. In fact, the Fed’s discount rate had been progressively lowered from 6 percent before the crash to 2.5 percent by early 1933.
More crucially, the “excess reserves” in the banking system grew dramatically during this forty-five-month period, implying just the opposite of monetary stringency. Prior to the stock market crash in September 1929, excess reserves in the banking system stood at $35 million, but then rose to $100 million by January 1931 and ultimately to $525 million by January 1933.
In short, the tenfold expansion of excess (i.e., idle) reserves in the banking system was dramatic proof that the banking system had not been parched for liquidity but was actually awash in it. The only mission the Fed failed to perform is one that Professor Friedman assigned to it thirty years after the fact; that is, to maintain an arbitrary level of M1 by forcing reserves into the banking system by means of open market purchases of Uncle Sam’s debt.
As it happened, the money supply (M1) did drop by about 23 percent during the same forty-five-month period in which excess reserves soared tenfold. As a technical matter, this meant that the money multiplier had crashed. As has been seen, however, the big drop in checking account deposits (the bulk of M1) did not represent a squeeze on money. It was merely the arithmetic result of the nearly 50 percent shrinkage of the commercial loan book during that period.
As previously detailed, this extensive liquidation of bad debt was an unavoidable and healthy correction of the previous debt bubble. Bank loans outstanding, in fact, had grown at manic rates during the previous fifteen years, nearly tripling from $14 billion to $42 billion. As in most credit-fueled booms, the vast expansion of lending during the Great War and the Roaring Twenties left banks stuffed with bad loans that could no longer be rolled over when the music stopped in October 1929.
Consequently, during the aftermath of the crash upward of $20 billion of bank loans were liquidated, including billions of write-offs due to business failures and foreclosures. As previously explained, nearly half of the loan contraction was attributable to the $9 billion of stock market margin loans which were called in when the stock market bubble collapsed in 1929.
Likewise, loan balances for working capital borrowings also fell sharply in the face of falling production. Again, this was the passive consequence of the bursting industrial and export sector bubble, not something caused by the Fed’s failure to supply sufficient bank reserves. In short, the liquidation of bank loans was almost exclusively the result of bubbles being punctured in the real economy, not stinginess at the central bank.
In fact, there has never been any wide-scale evidence that bank loans outstanding declined during 1930–1933 on account of banks calling performing loans or denying credit to solvent potential borrowers. Yet unless those things happened, there is simply no case that monetary stringency caused the Great Depression.
Friedman and his followers, including Bernanke, came up with an academic canard to explain away these obvious facts. Since the wholesale price level had fallen sharply during the forty-five months after the crash, they claimed that “real” interest rates were inordinately high after adjusting for deflation.
Yet this is academic pettifoggery. Real-world businessmen confronted with plummeting order books would have eschewed new borrowing for the obvious reason that they had no need for funds, not because they deemed the “deflation-adjusted” interest rate too high.
At the end of the day, Friedman’s monetary treatise offers no evidence whatsoever and simply asserts false causation; namely, that the passive decline of the money supply was the active cause of the drop in output and spending. The true causation went the other way: the nation’s stock of money fell sharply during the post-crash period because bank loans are the mother’s milk of bank deposits. So, as bloated loan books were cut down to sustainable size, the stock of deposit money (M1) fell on a parallel basis.
Given this credit collapse and the associated crash of the money multiplier, there was only one way for the Fed to even attempt to reflate the money supply. It would have been required to purchase and monetize nearly every single dime of the $16 billion of US Treasury debt then outstanding.
Today’s incorrigible money printers undoubtedly would say, “No problem.” Yet there is no doubt whatsoever that, given the universal antipathy to monetary inflation at the time, such a move would have triggered sheer panic and bedlam in what remained of the financial markets. Needless to say, Friedman never explained how the Fed was supposed to reignite the drooping money multiplier or, failing that, explain to the financial markets why it was buying up all of the public debt.
Beyond that, Friedman could not prove at the time of his writing A Monetary History of the United States in 1965 that the creation out of thin air of a huge new quantity of bank reserves would have caused the banking system to convert such reserves into an upwelling of new loans and deposits. Indeed, Friedman did not attempt to prove that proposition, either. According to the quantity theory of money, it was an a priori truth.
In actual fact, by the bottom of the depression in 1932, interest rates proved the opposite. Rates on T-bills and commercial paper were one-half percent and 1 percent, respectively, meaning that there was virtually no unsatisfied loan demand from credit-worthy borrowers. The dwindling business at the discount windows of the twelve Federal Reserve banks further proved the point. In September 1929 member banks borrowed nearly $1 billion at the discount windows, but by January 1933 this declined to only $280 million. In sum, banks were not lending because they were short of reserves; they weren’t lending because they were short of solvent borrowers and real credit demand.
In any event, Friedman’s entire theory of the Great Depression was thoroughly demolished by Ben S. Bernanke, his most famous disciple, in a real-world experiment after September 2008. The Bernanke Fed undertook massive open market operations in response to the financial crisis, purchasing and monetizing more than $2 trillion of treasury and agency debt.
As is by now transparently evident, the result was a monumental wheel-spinning exercise. The fact that there is now $1.7 trillion of “excess reserves” parked at the Fed (compared to a mere $40 billion before the crisis) meant that nearly all of the new bank reserves resulting from the Fed’s bond-buying sprees have been stillborn.
By staying on deposit at the central bank, they have fueled no growth at all of Main Street bank loans or money supply. There is no reason whatsoever, therefore, to believe that the outcome would have been any different in 1930–1932.
MILTON FRIEDMAN: FRESHWATER KEYNESIAN AND THE LIBERTARIAN PROFESSOR WHO FATHERED BIG GOVERNMENT
The great irony, then, is that the nation’s most famous modern conservative economist became the father of Big Government, chronic deficits, and national fiscal bankruptcy. It was Friedman who first urged the removal of the Bretton Woods gold standard restraints on central bank money printing, and then added insult to injury by giving conservative sanction to perpetual open market purchases of government debt by the Fed. Friedman’s monetarism thereby institutionalized a régime which allowed politicians to chronically spend without taxing.
Likewise, it was the free market professor of the Chicago school who also blessed the fundamental Keynesian proposition that Washington must continuously manage and stimulate the national economy. To be sure, Friedman’s “freshwater” proposition, in Paul Krugman’s famous paradigm, was far more modest than the vast “fine-tuning” pretensions of his “salt-water” rivals. The saltwater Keynesi
ans of the 1960s proposed to stimulate the economy until the last billion dollars of potential GDP was realized; that is, they would achieve prosperity by causing the state to do anything that was needed through a multiplicity of fiscal interventions.
By contrast, the freshwater Keynesian, Milton Friedman, thought that capitalism could take care of itself as long as it had precisely the right quantity of money at all times; that is, Friedman would attain prosperity by causing the state to do the one thing that was needed through the single spigot of M1 growth.
But the common predicate is undeniable. As has been seen, Friedman thought that member banks of the Federal Reserve System could not be trusted to keep the economy adequately stocked with money by voluntarily coming to the discount window when they needed reserves to accommodate business activity. Instead, the central bank had to target and deliver a precise quantity of M1 so that the GDP would reflect what economic wise men thought possible, not merely the natural level resulting from the interaction of consumers, producers, and investors on the free market.
For all practical purposes, then, it was Friedman who shifted the foundation of the nation’s money from gold to T-bills. Indeed, in Friedman’s scheme of things central bank purchase of Treasury bonds and bills was the monetary manufacturing process by which prosperity could be managed and delivered.
What Friedman failed to see was that one wise man’s quantity rule for M1 could be supplanted by another wise man’s quantity rule for M2 (a broader measure of money supply that included savings deposits) or still another quantity target for aggregate demand (nominal GDP targeting) or even the quantity of jobs created, such as the target of 200,000 per month recently enunciated by Fed governor Charles Evans. It could even be the quantity of change in the Russell 2000 index of stock prices, as Bernanke has advocated.
Yet it is hard to imagine a world in which any of these alternative “quantities” would not fall short of the “target” level deemed essential to the nation’s economic well-being by their proponents. In short, the committee of twelve wise men and women unshackled by Friedman’s plan for floating paper dollars would always find reasons to buy government debt, thereby laying the foundation for fiscal deficits without tears.
THE UNSEEN HAND NEVER REPORTED FOR WORK IN THE GLOBAL CURRENCY MARKETS
Open-ended monetization of US Treasury debt by the nation’s central bank was only part of the sound money demise triggered by the Camp David events. The decision to destroy Bretton Woods and float the dollar also caused an irreparable breakdown of international financial discipline.
Never again were trade accounts between nations properly settled, and most especially in the case of the United States. As previously indicated, the cumulative current account deficit since 1971 exceeds $8 trillion, meaning that Americans have borrowed one-half “turn” of national income from the rest of the world in order to live permanently beyond their means.
These massive US trade deficits have actually become a way of life since Camp David, yet they were not supposed to even happen. Professor Friedman advised the Nixon White House at the time that market forces would actually eliminate the incipient US trade deficit by “price discovery” of the “correct” market clearing exchange rates.
In this manner, floating exchange rates would continuously rebalance the flows of merchandise trade, direct investment, portfolio capital, and short-term financial instruments according to the changing circumstances of each nation. A global variant of Adam Smith’s “unseen hand” would supplant the financial stabilization and trade settlement functions of the old-fashioned gold standard that the discarded Bretton Woods system had been built upon.
In short, international markets would be cleared by the continuous repricing of exchange rates. This meant that deficit countries would suffer currency depreciation and surplus countries the opposite, thereby maintaining international payments equilibrium.
As previously demonstrated, this seemingly enlightened, pragmatic, and market-driven arrangement didn’t work in practice. As it turned out, Adam Smith’s unseen hand never even reported for work after Professor Friedman’s floating-rate contraption was put into global operation.
Instead of floating with market forces, exchange rates have been chronically and heavily manipulated by governments. This is especially the case with respect to the mercantilist nations of Asia in pursuit of an “export your way to prosperity” economic growth model.
In pegging their currencies far below market-clearing levels in monomaniacal pursuit of export advantage, Japan, China, South Korea, and the caravan of imitators along the East Asian rim accumulated more and more dollars. They then parked these excess dollars in Treasury bills and bonds, and sequestered the latter in the vaults of their central banks.
Over the years, these staggering accumulations of dollar liabilities have been labeled as “foreign exchange reserves” in deference to the wholly archaic notion that the dollar is a “reserve currency.” But the $7 trillion of dollar liabilities now held by foreign central banks are not classic monetary reserves at all.
The classic system’s monetary reserves were designed to function as international petty cash accounts; that is, world money in the form of gold was available to clear temporary imbalances in trade and capital flows between national currency areas. But the current system does not need petty cash reserves to clear international account imbalances because the latter can persist indefinitely so long as mercantilist nations peg their currencies.
Consequently, the more apt characterization of these vast dollar accumulations is that they are vendor-supplied export loans to the American economy. Like any other vendor loan, they are designed to enable American customers to collectively purchase foreign goods and services far in excess of their actual earnings on current production.
This continuous stream of vendor loans was heavily channeled into Treasury bonds and bills, along with the implicitly guaranteed paper of Fannie Mae and Freddie Mac. Thus, the true foundation of the post–Bretton Woods monetary system was US government debt. The latter became the medium of exchange which permitted Americans to consume far more than they produced, while enabling the developing Asian economies to export vastly more goods than their customers could afford.
Indeed, with the passage of time the swap of mercantilist nation exports for US government paper became embedded as the modus operandi of the global economy. Milton Friedman’s monetary contraption has thus become a ravenous consumer of Uncle Sam’s debt emissions, an outcome that the idealistic professor had apparently never even contemplated.
By the end of 2012, however, the facts were unassailable. After three decades of “deficits don’t matter” fiscal policy, the nation’s publicly held debt amounted to $11.5 trillion. Yet as indicated, a stunning $5 trillion, or nearly 50 percent, of that total was not held by private investors either at home or overseas. Instead, it had been sequestered in the vaults of central banks, including the Federal Reserve and those of major exporters.
MONETARY ROACH MOTELS:
THE BONDS WENT IN BUT NEVER CAME OUT
This freakish central bank accumulation of dollar liabilities, in turn, was the result of the greatest money-printing spree in world history. In essence, we printed and then they printed, and the cycle never stopped repeating. In this manner, the massive excess of dollar liabilities generated by the Fed were absorbed by its currency-pegging counterparts, and then recycled into swelling domestic money supplies of yuan, yen, won, ringgit, and Hong Kong dollars.
As the US debt-based global monetary system became increasingly more unstable in recent years, central bank absorption of incremental Treasury debt reached stunning proportions. Thus, United States publicly held debt rose by $6 trillion between 2004 and 2012, but upward of $4 trillion, or 70 percent, of this was taken down by central banks.
It could be truly said, therefore, that the world’s central banks have morphed into a global chain of monetary roach motels. The bonds went in, but they never came out. And therein
lays the secret of “deficits without tears.”
American politicians thus found themselves in the great fiscal sweet spot of world history. For several decades to come, they would have the unique privilege to issue bonds, notes, and bills from the US Treasury without limit. Only in the foggy future, when the world finally ran out of mercantilist rulers willing to swap the sweat of their people for Washington’s profligate debt emissions, would fiscal limits reemerge.
As it happened, not all American politicians immediately recognized that they had essentially died and gone to fiscal heaven. Hence in the first half of the 1990s, under George H. W. Bush and then President Bill Clinton, old-guard Republicans joined bourbon Democrats in the enactment of comprehensive fiscal plans that did actually reduce spending and raise new tax revenues.
But Bill Clinton’s courageously balanced budgets were the last hurrah of the old fiscal orthodoxy. These outcomes rested on a frail reed of personal conviction among politicians who had learned the fiscal rules of an earlier era.
In the emerging world of American crony capitalism, however, fiscal orthodoxy based on mere conviction untethered to real-world economic and financial pressures was not destined to survive. Instead, the assembled lobbies of K Street would soon have their way with the nation’s public purse.
In due course, the revenue base would be depleted in the name of spurring the growth of everything from ethanol plants to private aircraft to the gross national product itself. Meanwhile, the spending side of the budget became swollen with new subventions to the sick-care complex, the housing complex, the education behemoth, the farm subsidy harvesters’ alliance, and the alphabet soup of energy alternatives.
The Great Deformation Page 38