Bernanke on the Great Depression
A major result of last year's credit storm is a lingering sense of dread and foreboding among investors. Many are waiting for the proverbial "other shoe to drop" as the memories of last year's crisis, and its attendant economic effects, are still fresh in mind.
Until recently it was unthinkable to mainstream economists and pundits that an event as devastating as the Great Depression could occur in the U.S. The financial events of the past two years have altered their thinking, however, and now the "D-word" is bandied about in the news with the same liberality the word recession used to be.
But how did we arrive at this juncture so quickly? The torrid events of the past two years have had a profound affect on the attitudes of investors, consumers and producers alike. Much of the nation's collective psyche has been translated in this short period of time from what might be called an expansionist mindset to a contractionist psychology. To understand how this shift in attitude came about so quickly it will help to understand something of the history of the events leading up to the Great Depression of the 1930s. To gain some valuable insight into this watershed period in our nation's history, we'll refer to the narrative provided by Ben S. Bernanke, the current head of the Federal Reserve and the author of a series of academic research papers on the Depression. Many of his more influential papers have been collectively republished under the title, "Essays on the Great Depression," which was released in 2000 by the Princeton University Press. From this book I will quote liberally as we examine various aspects of the Great Depression and attempt to apply these lessons to the present time.
To many, the term "Great Depression" is a loaded term which evokes images of bread lines, men and women in tattered clothes and stock brokers jumping out of windows. The consensus view is that the Depression encompassed the entire period from 1930 to the early 1940s. Within this context it's easy to fall victim to the assumption that each year of the 1930s was a "depression" year in economic terms, but such was not the case. Within that 10-year period there were two major recessions: the first one from 1930 to 1933 and the second one from 1937-1938. The entire decade of the 1930s is described as a depression since overall levels of production were much lower than in the preceding times of economic normalcy. It's important to note that there can exist periods of severe contraction and also periods of recovery and limited expansion within the overall context of a long-term "depression."
Since there appears to be no consensus among economists as to how exactly to define a depression I'll offer my own definition for the purpose of this essay. A depression is an elongated period of limited economic production caused principally by a monetary contraction and characterized by contractionary psychology. Contractionary psychology believes that the way to survive a financial cataclysm is to focus on shrinkage and conservatism instead of production and expansion, whether on the personal or the business level. Even when money and credit are available in the financial system (as was the case from 1933 onward), the psychology of fear prevents lending institutions from making this money available. Further, the mental shock that a severe financial crisis engenders tends to linger until acted on by a catastrophic external force. The external force required to reverse depression psychology normally takes one of two major forms: a war or the partial or total replacement of the existing financial structure by a new one.
It's common knowledge that the Great Depression was catalyzed by the Great Stock Market Crash of 1929. Yet the details of this phenomenal event are often obscured by modern historians; it's root causes poorly understood. The economist and popular monetary lecturer of the 1970s and '80s, Dr. Stuart Crane, left nothing to the imagination in his vivid description of the inner workings leading up to the Great Crash. His intriguing narrative is worth repeating:
"In 1925, '26, '27 the Federal Reserve started its first real money game. Up until this time they were still cautious and hadn't really gotten the feel of things. They decided it was time to play round one of the milk game. What they did was they bid up stocks and up they were going. You start bidding up stocks a little, up limit, up limit, up limit, and the little guys were watching this take off and saying, 'Hey, let's go buy some.' And they go and buy a little. And they start making easy money, then pretty soon they're doubling up with 10 percent down, margin for the 90. But they're making millions. Every time stocks move up with a 10% rise they double their money. The only problem is that the opposite is true when stocks come down. It's great on the upswing and it's disaster on the way down. But for four years this game of pushing up stocks is played with the pundits declaring, 'There's no end, there's no horizon, it's going to last forever!'
"In March 1929 there was a little meeting in New York. After that meeting, Bernard Baruch sells out [of stocks], the Rockefellers sell out, the Kennedys sell out, all the big bankers sell out and the big people were out by August. Then the Federal Reserve cut the money supply four times in a month with four drastic reductions of the money supply. Then one day in October the banks called all their loans on all their margins in a minute. Every bank on the money desk - and these were call loans, callable on demand - all these people had their stock on margin borrowing 90% and they had to pay off now.
"Well they went to the banks and the banks and they were calling. They run to the market and everyone's trying to sell, who can buy? The banks had shut their loans off, the call desks were closed, the windows were slammed down. They shut all the money off and all these people were running around trying to sell; they had to sell 10% down and they were wiped out. All the people who weren't on the inside were gone." [Dr. Stuart Crane, New Brighton, Pa., lecture, 1981]
Bernanke also points to the Fed's involvement in bringing about the stock market crash of '29 in "Essays" when he writes, "Our analysis provides the clearest indictment of the Federal Reserve and U.S. monetary policy. Between mid-1928 and the financial crises that began in the spring of 1931, the Fed not only refused to monetize the substantial gold inflows to the United States but actually managed to convert positive reserve inflows into negative growth in the M1 money stock. Thus Fed policy was actively destabilizing in the pre-1931 period." He further concluded that "because of the size of the U.S. economy...our methods attribute a substantial portion of the worldwide deflation prior to 1931 to these policy decisions by the Federal Reserve." [Bernanke, p. 111].
Bernanke's commentary on the duration of the credit crisis of the early 1930s is instructive: "After struggling through 1931 and 1932, the financial system hit its low point in March 1933, when the newly elected President Roosevelt's 'bank holiday' closed down most financial intermediaries and markets. March 1933 was a watershed month in several ways: It marked not only the beginning of economic and financial recovery but also the introduction of truly extensive government involvement in all aspects of the financial system." This answers to the assertion made earlier in this essay that a depression usually requires the replacement of the existing financial structure with another one in order to end it.
There are many parallel observations that could be made linking March 1933 to March 2009 but that will have to wait for another commentary. Bernanke goes on to write, "It might be argued that the federally directed financial rehabilitation - which took strong measures against the problems of both creditors and debtors - was the only major New Deal program that successfully promoted economic recovery. In any case, the large government intervention is prima facie evidence that by this time the public had lost confidence in the self-correcting powers of the financial structure." [Bernanke pgs. 62-63]
The government's intervention didn't end the nation's money problems, though, as Bernanke explains. "Although the government's actions set the financial system on its way back to health, recovery was neither rapid nor complete. Many banks did not reopen after the holiday, and many that did open did so on a restricted basis or with marginally solvent balance sheets. Deposits did not flow back into the banks in great quantities until 1934, and the government...had to continue to pump large sums into banks and other intermediaries."
After the Great Crash of 1929 and the subsequent credit contraction there was also a major change in the attitude of lenders. Bernanke reports that following the 1930-33 bank crisis there was a shift of banks after this time away from making loans and toward holding safe and liquid investments. "The growing level of bank liquidity created an illusion (as Friedman and Schwartz pointed out) of easy money," Bernanke wrote. "However, the combination of lender reluctance and continued debtor insolvency interfered with credit flows for several years after 1933."
The fate of the nation was first tipped in favor of the deflationists when in 1928 the Fed began pursuing a tight money policy. Bernanke observed, "It is now rather widely accepted that Federal Reserve policy turned contractionary in 1928, in an attempt to curb stock market speculation." Bernanke also asserted that U.S. nominal money growth from 1928 through 1929 was precisely zero. [pg. 153]
The Fed, according to Bernanke, began consciously tightening money in 1928. The U.S. was on the gold standard at that time and the Fed's tight money policy resulted in a sterilization of induced gold flows. Consequently, the U.S. monetary base fell roughly 6 percent between June 1928 and June 1930 in spite of a more than 10 percent increase in U.S. gold reserves during the same period. "This flow of gold into the United States," states Bernanke, "drained the reserves of other gold-standard countries and forced them into parallel tight-money policies." Thus there was a coordinated global depression as a result of the Fed's tight money stance.
The Federal Reserve under Greenspan would make the same mistaken in 2004-05 in its decision to halt money supply growth for the stated purpose of curbing real estate speculation. Instead of easing off the money growth accelerator around mid-2003 and following the lead of the Treasury yield, the Fed chose the drastic measure of a progressively tight money strategy. The financial markets, and eventually the retail economy, suffered the inevitable fate. Mr. Bernanke now has a real-life laboratory in which to apply his theories.
Another aspect of the Great Depression well known to students of history was the bank crisis. Bank failures were a common feature of the early 1930s and Bernanke estimates that the percentages of operating banks which failed in each year from 1930 to 1933 to be 5.6%, 10.5%, 7.8% and 12.9%, respectively. By the end of 1933 the number of banks operating was just half the number that existed in 1929, a fact Bernanke attributes to a variety of factors ranging from failures to mergers. Banks that managed to survive these rough years experienced "heavy losses." [Bernanke, pg. 44]
The decline in the amount of business loans made available by banks was partly offset by what Bernanke terms as "outside sources," including merchant credit. "For the period from 1921 until the bank holiday, and with monetary variables included, the total effect of credit contraction on output was large," he writes, "negative, and significant at the 95 percent levels....the recovery of 1933-41 was financed by nonbank sources, with bank loans remaining at a low level." [Bernanke, pg. 60]
Today the banks find themselves in a similar situation. Even as the infusion of government rescue money continues to swell their books, the larger banks are still suffering from shell-shock from last year's crisis; as a result, loan volumes are significantly diminished. Bankers' new found conservatism in lending has kept some sectors of the economy from sharing in the recovery this year. If Bernanke's observation regarding the banks' reluctance to loan throughout the duration of the Depression in the 1930s holds true today, where might the alternative sources of financing come from? It seems evident that now, as was true in the 1930s, the economic recovery will almost certainly be financed by non-bank sources.
As any economic observer can see, whenever talk turns of today's economic trouble and parallels are drawn between today and the Great Depression, the debate tends to be one-sided nature. Doing a simple Google search on the Internet of key words related to today's crisis will invariably yield hundreds of entries linking to opinion pieces and research papers that all seem to have one common conclusion: depression is unavoidable in the wake of the credit crisis and nothing can be done to avert it. Trying to find an unbiased, unemotional analysis of the credit crisis is a nearly impossible task. Searching for discussions of alternative credit and financing sources is extremely difficult at best, even in respect to historical studies of the Great Depression. It seems that whenever discussion of depression begins, emotion takes over completely and rationality exits.
Do we believe, as the doomsayers assert, that consumers and producers in the aggregate will collectively go into a long-term cocoon and refuse to do any significant spending for production or personal consumption? That the aggregate economic activity of the average American household will mainly center around paying down debt and shoring up savings? Do we further believe that in a commerce- and consumption-driven nation like ours the impulse toward creativity, ingenuity and innovation could be so quickly supplanted by the paralyzing fear engendered by last year's credit storm? That the American instinct towards economic expansion, which has been ingrained for over a century, could be halted in its tracks by a two-year financial reversal?
While I can't prove conclusively that the doomsayers are wrong to suggest the second Great Depression has already begun (such things can only be known in retrospect), I can offer some pertinent analogies from the extraordinary events of recent years. The 9/11 catastrophe is one such example. In the wake of Sept. 11, 2001, the economy temporarily ground to a halt. Building projects were abandoned for a few days, people were afraid to leave their homes and nearly every economic endeavor surrendered to the terror of the moment. Yet within four months of this catastrophic event the runaway phase of the real estate bubble was underway as the contractionary psychology of 9/11 gave way to an economic expansion.
Another example would be the historic hurricane season of 2005. After one particularly violent storm which saw entire coastal communities devastated and sometimes completely destroyed, not more than a few months pass before the memory of the obliteration was erased and rebuilding efforts begin. The fear of the storm subsided, as it always does, and a renewed cycle of economic activity was underway as if nothing had happened at all. So in like manner is the rebound after an onerous financial storm. The only thing that can delay a recovery is the conscious refusal of the monetary authorities of allowing much needed liquidity to get where it's needed most. This is an aspect of the late credit storm that requires more examination (unfortunately more than can be given in this discussion).
Dr. Crane provides us with another analogy from the Great Depression applicable to the present time: "Now Bernard Baruch and the boys now pulled another one. With Franklin in the White House, Franklin started moving the price of gold up and down, up and down, up and down to where nobody knew where it was going to be. Since all contracts made were payable in gold and still under gold obligations, nobody could lend in 1933 for a simple reason: they didn't know what they were going to get paid back in. So the lenders had to say, 'Wait a minute, we're going to stop lending until the gold price settles down.' Well it didn't settle down; Roosevelt moved it every day. It was $23 one day, then $26 another, then $29 another, then a big drop, all very erratically. The chaos in the money market was so bad that all the money dried up. Then Roosevelt goes on the radio and says, 'The bankers won't lend, the nation's finances have been dried up, we now have to have a national emergency," and he declares a bank holiday."
Dr. Crane was always fond of quoting Roosevelt's infamous phrase, "If it happens [in politics] you can bet it was planned that way." He also used to say that the reason for any economic crisis can always be seen when analyzing its results: "Somebody always wins in a financial crash, just ask yourself who the winners are. The losers are everywhere easy to find. But who gains from these crises? Is it not that the government gets bigger at everyone else's expense?"
Many pundits are claiming the government has lost its control over the affairs of the economy and is was much a victim of the financial crisis as everyone else. This can't be believed, for the nation's financial affairs are always tightly controlled with events such as the credit crisis known well in advance of their occurrences. Simply put, the government hasn't lost control over the economy and never did.
The results of the Great Depression were evident in retrospect, for it allowed the federal government to expand its economic purview and regulatory authority in ways that would have been impossible without the pretext of a great crisis. Bernanke contrasts the relative lack of economic control enjoyed by the Fed before the Depression with the far greater control it exerted had over the banking system afterwards. He points out that with the gold standard that was in place in the 1920s and early '30s, open market operations weren't permitted or else were severely restricted. "This limitation on central bank powers was usually the result of the stabilization programs of the early and mid 1920s," he writes. "By prohibiting central banks from holding or dealing in significant quantities of government securities, and thus making monetization of deficits more difficult, the architects of the stabilizations hoped to prevent future inflation. This forced the central banks to rely on discount policy...as the principal means of affecting the domestic money supply. However, in a number of countries the major commercial banks borrowed very infrequently from the central banks, implying that except in crisis periods the central bank's control over the money supply might be quite weak."
One major result of the Great Depression was that it allowed the central government through the Federal Reserve to hold greater control over monetary policy through its use of a flexible currency. When the government obtained its increased control over the private sector, the arteries of finance became suddenly unclogged and commerce again started flourishing. When will banks start lending again? As soon as the government has achieved its ultimate objective in consolidating its control over its targeted areas of the private sector, the storm clouds will be lifted and lending activity will begin anew.
In the meantime, the recovery will have to rely on those "non-bank sources of financing" Bernanke talked about.