One hundred years ago today the
world was shook loose of its moorings. Every school boy knows that
the assassination of the archduke of Austria at Sarajevo was the trigger
that incited the bloody, destructive conflagration of the world’s nations known
as the Great War. But this senseless eruption of
unprecedented industrial state violence did not end with
the armistice four years later.
In fact, 1914 is the fulcrum of modern history. It is
the year the Fed opened-up for business just as the carnage in northern
France closed-down the prior magnificent half-century era of liberal
internationalism and honest gold-backed money. So it was the Great War’s
terrible aftermath—–a century of drift toward statism, militarism and fiat
money—-that was actually triggered by the events at Sarajevo.
Unfortunately, modern historiography wants to keep the Great War
sequestered in a four-year span of archival curiosities about battles, mustard
gas and monuments to the fallen. But the opposite historiography is more
nearly the truth. The assassins at Sarajevo triggered the very warp and woof of
the hundred years which followed.
The Great War was self-evidently an epochal calamity, especially
for the 20 million combatants and civilians who perished for no reason that is
discernible in any fair reading of history, or even unfair one. Yet the far
greater calamity is that Europe’s senseless fratricide of 1914-1918 gave
birth to all the great evils of the 20th century— the Great Depression,
totalitarian genocides, Keynesian economics, permanent warfare
states, rampaging central banks and the exceptionalist-rooted follies of
America’s global imperialism.
Indeed, in Old Testament fashion, one begat the next and the
next and still the next. This chain of calamity originated in the Great War’s
destruction of sound money, that is, in the post-war demise of the pound
sterling which previously had not experienced a peacetime change in its gold
content for nearly two hundred years.
Not unreasonably, the world’s financial system had become anchored
on the London money markets where the other currencies traded at fixed exchange
rates to the rock steady pound sterling—which, in turn, meant that prices and
wages throughout Europe were expressed in common money and tended toward
transparency and equilibrium.
This liberal international economic order—that is, honest money,
relatively free trade, rising international capital flows and rapidly growing
global economic integration—-resulted in a 40-year span between 1870 and
1914 of rising living standards, stable prices, massive capital investment and
prolific technological progress that was never equaled—either before or
since.
During intervals of war, of course, 19th century
governments had usually suspended gold convertibility and open trade in the heat
of combat. But when the cannons fell silent, they had also endured the
trauma of post-war depression until wartime debts had been liquidated and
inflationary currency expedients had been wrung out of the circulation. This
was called “resumption” and restoring convertibility at the peacetime parities
was the great challenge of post-war normalizations.
The Great War, however, involved a scale of total industrial
mobilization and financial mayhem that was unlike any that had gone before.
In the case of Great Britain, for example, its national debt increased
14-fold, its price level doubled, its capital stock was depleted, most
off-shore investments were liquidated and universal wartime conscription left
it with a massive overhang of human and financial liabilities.
Yet England was the least devastated. In France, the price level
inflated by 300 percent, its extensive Russian investments were confiscated by
the Bolsheviks and its debts in New York and London catapulted to more than 100
percent of GDP.
Among the defeated powers, currencies emerged nearly worthless
with the German mark at five cents on the pre-war dollar, while wartime
debts—especially after the Carthaginian peace of Versailles—–soared to
crushing, unrepayable heights.
In short, the bow-wave of debt, currency inflation and financial
disorder from the Great War was so immense and unprecedented that the classical
project of post-war liquidation and “resumption” of convertibility was destined
to fail. In fact, the 1920s were a grinding, sometimes inspired but
eventually failed struggle to resume the international gold standard, fixed
parities, open world trade and unrestricted international capital flows.
Only in the final demise of these efforts after 1929 did the
Great Depression, which had been lurking all along in the post-war shadows,
come bounding onto the stage of history.
America’s Needless Intervention
In The Great War And The Ensuing Chain of 20th Century Calamities
The Great Depression’s tardy, thoroughly misunderstood and
deeply traumatic arrival happened compliments of the United States. In the
first place, America’s wholly unwarranted intervention in April 1917 prolonged
the slaughter, doubled the financial due bill and generated a cockamamie peace,
giving rise to totalitarianism among the defeated powers and Keynesianism among
the victors. Choose your poison.
Even conventional historians like Niall Ferguson admit as much.
Had Woodrow Wilson not misled America on a messianic crusade, the Great War
would have ended in mutual exhaustion in 1917 and both sides would have gone
home battered and bankrupt but no danger to the rest of mankind. Indeed, absent
Wilson’s crusade there would have been no allied victory, no punitive peace,
and no war reparations; nor would there have been a Leninist coup in Petrograd
or Stalin’s barbaric regime.
Likewise, Churchill’s starvation blockade would not have
devastated post-Armistice Germany, nor would there have been the humiliating signing
of the war guilt clause by German officials at Versailles. And the
subsequent financial chaos of 1919-1923 would not have happened either—-meaning
no “stab in the back” myth, no Hitler, no Nazi dystopia, no Munich, no
Sudetenland and Danzig corridor crises, no British war to save Poland, no final
solution and holocaust, no global war against Germany and Japan and no
incineration of 200,000 civilians at Hiroshima and Nagasaki.
Nor would there have followed a Cold War with the Soviets or CIA
sponsored coups and assassinations in Iran, Guatemala, Indonesia, Brazil, Chile
and the Congo, to name a few. Surely there would have been no CIA plot to
assassinate Castro, or Russian missiles in Cuba or a crisis that took the world
to the brink of annihilation. There would have been no Dulles brothers, no
domino theory and no Vietnam slaughter, either.
Nor would we have launched Charlie Wilson’s War to arouse the
mujahedeen and train the future al Qaeda. Likewise, there would have been no
shah and his Savak terror, no Khomeini-led Islamic counter-revolution, no US
aid to enable Saddam’s gas attacks on Iranian boy soldiers in the 1980s.
Nor would there have been an American invasion of Arabia in 1991
to stop our erstwhile ally Hussein from looting the equally contemptible Emir
of Kuwait’s ill-gotten oil plunder—or, alas, the horrific 9/11 blowback a
decade later.
Most surely, the axis-of-evil—-that is, the Washington-based
Cheney-Rumsfeld-neocon axis—- would not have arisen, nor would it have foisted
a $1 trillion Warfare State budget on 21st century America.
The 1914-1929 Boom Was An
Artifact of War And Central Banking
A second crucial point is that the Great War enabled the
already rising American economy to boom and bloat in an entirely artificial and
unsustainable manner for the better part of 15 years. The exigencies of war
finance also transformed the nascent Federal Reserve into an incipient
central banking monster in a manner wholly opposite to the intentions of its
great legislative architect—the incomparable Carter Glass of Virginia.
During the Great War America became the granary and arsenal to the
European Allies—-triggering an eruption of domestic investment and production
that transformed the nation into a massive global creditor and powerhouse
exporter virtually overnight.
American farm exports quadrupled, farm income surged from
$3 billion to $9 billion, land prices soared, country banks proliferated like
locusts and the same was true of industry. Steel production, for example, rose
from 30 million tons annually to nearly 50 million tons during the war.
Altogether, in six short years $40 billion of money GDP became
$92 billion in 1920—a sizzling 15 percent annual rate of gain.
Needless to say, these fantastic figures reflected an
inflationary, war-swollen economy—-a phenomena that prudent finance men of the
age knew was wholly artificial and destined for a thumping post-war depression.
This was especially so because America had loaned the Allies massive amounts of
money to purchase grain, pork, wool, steel, munitions and ships. This transfer
amounted to nearly 15 percent of GDP or $2 trillion equivalent in today’s
economy, but it also amounted to a form of vendor finance that was destined to
vanish at war’s end.
Carter Glass’ Bankers’ Bank:
The Antithesis Of Monetary Central Planning
As it happened, the nation did experience a brief but deep recession
in 1920, but this did not represent a thorough-going end-of-war “de-tox” of the
historical variety. The reason is that America’s newly erected Warfare
State had hijacked Carter Glass “banker’s bank” to finance Wilson’s crusade.
Here’s the crucial background: When Congress acted on Christmas
Eve 1913, just six months before Archduke Ferdinand’s assassination, it
had provided no legal authority whatsoever for the Fed to buy government bonds
or undertake so-called “open market operations” to finance the public debt.
In part this was due to the fact that there were precious few Federal
bonds to buy. The public debt then stood at just $1.5 billion, which is
the same figure that had pertained 51 years earlier at the battle of
Gettysburg, and amounted to just 4 percent of GDP or $11 per capita.
Thus, in an age of balanced budgets and bipartisan fiscal
rectitude, the Fed’s legislative architects had not even considered the
possibility of central bank monetization of the public debt, and, in any event,
had a totally different mission in mind.
The new Fed system was to operate decentralized “reserve banks”
in 12 regions—most of them far from Wall Street in places like San Francisco,
Dallas, Kansas City and Cleveland. Their job was to provide a passive
“rediscount window” where national banks within each region could bring sound,
self-liquidating commercial notes and receivables to post as collateral in
return for cash to meet depositor withdrawals or to maintain an approximate 15
percent cash reserve.
Accordingly, the assets of the 12 reserve banks were to consist
entirely of short-term commercial paper arising out of the ebb and flow of
commerce and trade on the free market, not the debt emissions of Washington.
In this context, the humble task of the reserve banks was to don green
eyeshades and examine the commercial collateral brought by member banks, not to
grandly manage the macro economy through targets for interest rates, money
growth or credit expansion—to say nothing of targeting jobs, GDP, housing starts
or the Russell 2000, as per today’s fashion.
Even the rediscount rate charged to member banks for cash loans
was to float at a penalty spread above money market rates set by supply and
demand for funds on the free market.
The big point here is that Carter Glass’ “banker’s bank” was an
instrument of the market, not an agency of state policy. The so-called economic
aggregates of the later Keynesian models—-GDP, employment, consumption and
investment—were to remain an unmanaged outcome on the free market, reflecting
the interaction of millions of producers, consumers, savers, investors,
entrepreneurs and even speculators.
In short, the Fed as “banker’s bank” had no dog in the GDP hunt.
Its narrow banking system liquidity mission would not vary whether the aggregates
were growing at 3 percent or contracting at 3 percent.
What would vary dramatically, however, was the free market
interest rate in response to shifts in the demand for loans or supply of
savings. In general this meant that investment booms and speculative
bubbles were self-limiting: When the demand for credit sharply out-ran the
community’s savings pool, interest rates would soar—thereby rationing demand
and inducing higher cash savings out of current income.
This market clearing function of money market interest rates was
especially crucial with respect to leveraged financial speculation—such as
margin trading in the stock market. Indeed, the panic of 1907 had
powerfully demonstrated that when speculative bubbles built up a powerful head
of steam the free market had a ready cure.
In that pre-Fed episode, money market rates soared to 20, 30 and
even 90 percent at the peak of the bubble. In short order, of course,
speculators in copper, real estate, railroads, trust banks and all manner of
over-hyped stock were carried out on their shields—-even as JPMorgan’s men, who
were gathered as a de facto central bank in his library on Madison Avenue,
selectively rescued only the solvent banks with their own money at-risk.
Needless to say, these very same free market interest rates were
a mortal enemy of deficit finance because they rationed the supply of savings
to the highest bidder. Thus, the ancient republican moral verity of balanced
budgets was powerfully reinforced by the visible hand of rising interest rates:
deficit spending by the public sector automatically and quickly crowded out
borrowing by private households and business.
How The Bankers’ Bank Got
Hijacked To Fund War Bonds
And this brings us to the Rubicon of modern Warfare State
finance. During World War I the US public debt rose from $1.5 billion to
$27 billion—an eruption that would have been virtually impossible without
wartime amendments which allowed the Fed to own or finance U.S. Treasury debt.
These “emergency” amendments—it’s always an emergency in wartime—enabled
a fiscal scheme that was ingenious, but turned the Fed’s modus operandi upside
down and paved the way for today’s monetary central planning.
As is well known, the Wilson war crusaders conducted massive
nationwide campaigns to sell Liberty Bonds to the patriotic masses. What is far
less understood is that Uncle Sam’s bond drives were the original case of no
savings? No credit? No problem!
What happened was that every national bank in America conducted
a land office business advancing loans for virtually 100 percent of the war
bond purchase price—with such loans collateralized by Uncle Sam’s guarantee.
Accordingly, any patriotic American with enough pulse to sign the loan papers
could buy some Liberty Bonds.
And where did the commercial banks obtain the billions they
loaned out to patriotic citizens to buy Liberty Bonds? Why the Federal
Reserve banks opened their discount loan windows to the now eligible collateral
of war bonds.
Additionally, Washington pegged the rates on these loans below
the rates on its treasury bonds, thereby providing a no-brainer arbitrage
profit to bankers.
Through this backdoor maneuver, the war debt was thus massively
monetized. Washington learned that it could unplug the free market
interest rate in favor of state administered prices for money, and that credit
could be massively expanded without the inconvenience of higher savings out of
deferred consumption. Effectively, Washington financed Woodrow Wilson’s
crusade with its newly discovered printing press—-turning the innocent
“banker’s bank” legislated in 1913 into a dangerously potent new arm of the
state.
Bubbles Ben 1.0
It was this wartime transformation of the Fed into an activist
central bank that postponed the normal post-war liquidation—-moving the world’s
scheduled depression down the road to the 1930s. The Fed’s role in this
startling feat is in plain sight in the history books, but its significance has
been obfuscated by Keynesian and monetarist doctrinal blinders—that is, the
presumption that the state must continuously manage the business cycle and
macro-economy.
Having learned during the war that it could arbitrarily peg the
price of money, the Fed next discovered it could manage the growth of bank
reserves and thereby the expansion of credit and the activity rate of the wider
macro-economy. This was accomplished through the conduct of “open market
operations” under its new authority to buy and sell government bonds and
bills—something which sounds innocuous by today’s lights but was actually the
fatal inflection point. It transferred the process of credit creation from the
free market to an agency of the state.
As it happened, the patriotic war bond buyers across the land
did steadily pay-down their Liberty loans, and, in turn, the banking system
liquidated its discount window borrowings—-with a $2.7 billion balance in 1920
plunging 80 percent by 1927. In classic fashion, this should have caused the
banking system to shrink drastically as war debts were liquidated and war-time
inflation and malinvestments were wrung out of the economy.
But big-time mission creep had already set in. The
legendary Benjamin Strong had now taken control of the system and on repeated
occasions orchestrated giant open market bond buying campaigns to offset the
natural liquidation of war time credit.
Accordingly, treasury bonds and bills owned by the Fed
approximately doubled during the same 7-year period. Strong justified his
Bernanke-like bond buying campaigns of 1924 and 1927 as helpful actions to
off-set “deflation” in the domestic economy and to facilitate the return of
England and Europe to convertibility under the gold standard.
But in truth the actions of Bubbles Ben 1.0 were every bit as
destructive as those of Bubbles Ben 2.0.
In the first place, deflation was a good thing that was supposed
to happen after a great war. Invariably, the rampant expansion of war time debt
and paper money caused massive speculations and malinvestments that needed to
be liquidated.
The Bank of England’s Perfidy
Likewise, the barrier to normalization globally was that England
was unwilling to fully liquidate its vast wartime inflation of wage, prices and
debts. Instead, it had come-up with a painless way to achieve “resumption”
at the age-old parity of $4.86 per pound; namely, the so-called gold exchange
standard that it peddled assiduously through the League of Nations.
The short of it was that the British convinced France, Holland,
Sweden and most of Europe to keep their excess holdings of sterling exchange on
deposit in the London money markets, rather than convert it to gold as under
the classic, pre-war gold standard.
This amounted to a large-scale loan to the faltering British
economy, but when Chancellor of the Exchequer Winston Churchill did resume
convertibility in April 1925 a huge problem soon emerged. Churchill’s
splendid war had so debilitated the British economy that markets did not
believe its government had the resolve and financial discipline to maintain the
old $4.86 parity. This, in turn, resulted in a considerable outflow of gold
from the London exchange markets, putting powerful contractionary pressures on
the British banking system and economy.
Real Cause of the Great Depression: Collapse of the Artificial 1914-1929 Boom
In this setting, Bubbles Ben 1.0 (New York Fed
Governor Benjamin Strong) stormed in with a rescue plan that will
sound familiar to contemporary ears. By means of his bond buying campaigns he
sought to drive-down interest rates in New York relative to London, thereby
encouraging British creditors to keep their money in higher yielding sterling
rather than converting their claims to gold or dollars.
The British economy was thus given an option to keep
rolling-over its debts and to continue living beyond its means. For a few years
these proto-Keynesian “Lords of Finance” —- principally Ben Strong of the Fed
and Montague Norman of the BOE—-managed to kick the can down the road.
But after the Credit Anstalt crisis in spring 1931, when
creditors of shaky banks in central Europe demanded gold, England’s precarious
mountain of sterling debts came into the cross-hairs. In short order, the
money printing scheme of Bubbles Ben 1.0 designed to keep the Brits in cheap
interest rates and big debts came violently unwound.
In late September a weak British government defaulted on its
gold exchange standard duty to convert sterling to gold, causing the French,
Dutch and other central banks to absorb massive overnight losses. The global
depression then to took another lurch downward.
Inventing Bubble Finance
: The Call Money Market Explosion Before 1929
But central bankers tamper with free market interest rates only
at their peril—-so the domestic malinvestments and deformations which flowed
from the monetary machinations of Bubbles Ben 1.0 were also monumental.
Owing to the splendid tax-cuts and budgetary surpluses of
Secretary Andrew Mellon, the American economy was flush with cash, and due to
the gold inflows from Europe the US banking system was extraordinarily liquid.
The last thing that was needed in Roaring Twenties America was the cheap
interest rates—-at 3 percent and under—that resulted from Strong’s meddling in
the money markets.
At length, Strong’s ultra-low interest rates did cause credit
growth to explode, but it did not end-up funding new steel mills or auto
assembly plants. Instead, the Fed’s cheap debt flooded into the Wall
Street call money market where it fueled that greatest margin debt driven stock
market bubble the world had ever seen. By 1929, margin debt on Wall Street had
soared to 12 percent of GDP or the equivalent of $2 trillion in today’s economy
(compared to $450 billion at present).
The Original Sub-Prime: Wall
Street’s 1920s Foreign Bond Mania
As is well known, much economic carnage resulted from the Great
Crash of 1929. But what is less well understood is that the great stock market
bubble also spawned a parallel boom in foreign bonds—-a specie of Wall Street
paper that soon proved to be the sub-prime of its day. Indeed, Bubbles Ben 1.0
triggered a veritable cascade of speculative borrowing that soon spread to the
far corners of the globe, including places like municipality of Rio de Janeiro,
the Kingdom of Denmark and the free city of Danzig, among countless others.
It seems that the margin debt fueled stock market drove equity
prices so high that big American corporations with no needs for cash were
impelled to sell bundles of new stock anyway in order to feed the insatiable
appetites of retail speculators. They then used the proceeds to buy Wall
Street’s high yielding “foreign bonds”, thereby goosing their own reported
earnings, levitating their stock prices even higher and causing the cycle to be
repeated again and again.
As the Nikkei roared to 40,000 in the late 1980s, the Japanese
were pleased to call this madness “zaitech”, and it didn’t work any better the
second time around. But the 1920s version of zaitech did generate prodigious
sums of cash that foreign borrowers cycled right back to exports from
America’s farms, mines and factories. Over the eight years ending in
1929, the present day equivalent of $1.5 trillion was raised on Wall
Street’s red hot foreign bond market, meaning that the US economy simply
doubled-down on the vendor finance driven export boom that had been originally
sparked by the massive war loans to the Allies.
In fact, over the period 1914-1929 the U. S. loaned overseas
customers—-from the coffee plantations of Brazil to the factories of the
Ruhr—-the modern day equivalent of $3.5 trillion to prop-up demand for American
exports. The impact was remarkable. In the 15 years before the war American
exports had crept up slowly from $1.6 billion to $2.4 billion per year, and
totaled $35 billion over the entire period. By contrast, shipments from
American farms and factors soared to nearly $11 billion annually by 1919 and
totaled $100 billion—three times more—over the 15 years through 1929.
So this was vendor finance on a vast scale——reflecting the exact
mercantilist playbook that Mr. Deng chanced upon 60 years later when he opened
the export factories of East China, and then ordered the People’s Bank to
finance China’s exports of T-shirts, sneakers, plastic extrusions, zinc
castings and mini-backhoes via the continuous massive purchases of Uncle Sam’s
bonds, bills and guaranteed housing paper.
Our present day Keynesian witch doctors antiseptically label the
$3.8 trillion that China has accumulated through this massive currency
manipulation and repression as “foreign exchange reserves”, but they are
nothing of the kind. If China had honest exchange rates, it reserves would be a
tiny sliver of today’s level.
In truth, China’s $3.8 trillion of reserves are a gigantic
vendor loan to its customers. This is a financial clone of the $3.5 trillion
equivalent that the great American creditor and export powerhouse loaned to the
rest of the world between 1914 and 1929.
Needless to say, after the October 1929 crash, the Wall Street
foreign bond market went stone cold, with issuance volume dropping by 95
percent within a year or two. Thereupon foreign bond default rates suddenly
soared because sub-prime borrowers all over the world had been engaged in a
Ponzi—-tapping new money on Wall Street to pay interest on the old loans.
By 1931 foreign bonds were trading at 8 cents on the dollar—-not
coincidentally in the same busted zip code where sub-prime mortgage bonds ended
up in 2008-2009.
Still, busted bonds always mean a busted economic cycle until
the malinvestments they initially fund can be liquidated or repurposed. Thus,
the 1929 Wall Street bust generated a devastating crash in US exports as the
massive vendor financed foreign demand for American farm and factory goods
literally vanished. By 1933 exports had slipped all the way back to the
$2.4 billion level of 1914.
1929-1933 Foreign Bond and US
Export Bust: True Source of the Great Depression
That’s not all. As US export shipments crashed by 70 percent
between 1929 and 1933, there were ricochet effect throughout the domestic
economy.
This artificial 15-year export boom had caused the production
capacity of American farms and factories to become dramatically oversized,
meaning that during this interval there had occurred a domestic capital
spending boom of monumental proportions. While estimated GDP grew by a
factor of 2.5X during 1914-1929, capital spending by manufacturers rose by 7X.
Auto production capacity, for example, increased from 2 million vehicles
annually in 1920 to more than 6 million by 1929.
Needless to say, when world export markets collapsed, the US
economy was suddenly drowning in excess capacity. In short order, the
decade-long capital spending boom came to a screeching halt, with annual
outlays for plant and equipment tumbling by 80 percent in the four years after
1929, and shipments of items like machine tools plummeting by 95 percent.
Not surprisingly, in the wake of this drastic downshift in
output, American business also found itself drowning in excess inventories.
Accordingly, nearly half of all production inventories extant in 1929
were liquidated by 1933, resulting in a shocking 20 percent hit to GDP—a blow
that would amount to a $3 trillion drop in today’s economy.
Finally, Bubbles Ben 1.0 had induced vast but temporary “wealth
effects” just like his present day successor. Stock prices surged by 150
percent in the final three years of the mania. There was also an explosion of
consumer installment loans for durable goods and mortgages for homes.
Indeed, mortgage debt soared by nearly 4X during the decade before the crash,
while boom-time sales of autos, appliances and radios nearly tripled durable
goods sales in the eight years ending in 1929.
All of this debt and wealth effects induced spending came to an
abrupt halt when stock prices came tumbling back to earth. Durable goods
and housing plummeted by 80 percent during the next four years. In the case of
automobiles, where stock market lottery winners had been buying new cars hand
over fist, the impact was especially far reaching. After sales peaked at 5.3
million units in 1929, they dropped like a stone to 1.4 million vehicles in
1932, meaning that this 75 percent shrinkage of auto sales cascaded through the
entire auto supply chain including metal working equipment, steel, glass,
rubber, electricals and foundry products.
Thus, the Great Depression was born in the extraordinary but
unsustainable boom of 1914-1929 that was, in turn, an artificial and bloated
project of the warfare and central banking branches of the state, not the free
market. Nominal GDP, which had been deformed and bloated to $103 billion by
1929, contracted massively, dropping to only $56 billion by 1933.
Crucially, the overwhelming portion of this unprecedented
contraction was in exports, inventories, fixed plant and durable goods—the very
sectors that had been artificially hyped. These components declined by
$33 billion during the four year contraction and accounted for fully 70 percent
of the entire drop in nominal GDP.
So there
was no mysterious loss of that Keynesian
economic ether called “aggregate demand”, but only the
inevitable shrinkage of a state induced boom. It was not the depression bottom
of 1933 that was too low, but the wartime debt and speculation bloated peak in
1929 that had been unsustainably too high.
Reprinted with permission from David Stockman.
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