Revisionist View of the Great Depression - Part I

By: Antal E. Fekete | Tue, May 7, 2002
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Summary
Following John Maynard Keynes, mainstream economists hold that the Great Depression was caused by 'contractionist tendencies' of the gold standard. In this revisionist view we shall argue that just the opposite is true: it was the destruction of the gold standard by the government that caused the unprecedented collapse in the world economy. The chain of causation was as follows. Interest rates were cut adrift from their gold moorings by the politicians. Bond speculators were unleashed. Chief among them were the banks. For them the new dispensation was a matter of life or death. The banks were insolvent. They were gambling that they might be able to plug the enormous holes in the balance sheet with capital gains in the bond portfolio, that is, by oushing interest rates down. But there was another factor that made the case for bond speculation compelling. The risks involved, well past the range of prudence of bank portfolio management, were removed by the ban on gold hoarding. This ban has created a captive market for bonds. Previously those individuals who wanted to manage their liquid wealth most conservatively would park it in gold. As this was no longer legally possible, they now had to park it in government bonds. Thus the banks' risk that interest rates would turn against their speculative long position in bonds were removed. This explains the extraordinary virulence of the speculative orgy driving bond prices up or, what is the same to say, driving interest rates down.

Using fundamental principles of accounting we shall prove our main thesis asserting that falling interest rates squeeze the profits of productive enterprise. Worse still, in the 1930's the squeeze was concealed by the accounting code which ill-advised politicians had relaxed at the start of World War I. As a result losses were reported as profits and phantom profits were paid out as dividends to shareholders. There was a hidden destruction of capital across the board. More precisely, capital was clandestinely siphoned off from the balance sheet of the productive sector to show up in the form of capital gains in the balance sheet of the financial sector. The collapse of production was not caused by the collapse of demand as asserted by Keynes. Rather, the collapse of demand was caused by the collapse of production, which could have been avoided by keeping the interest-rate structure stable, as it has always been under the gold standard, shutting out bond speculation. The economists' profession would do well to re-examine its prejudices and prepossessions about the gold standard. The urgency of this task is all the more pressing in view of the unfolding deflationary scenario. Once more, the interest-rate structure appears to be falling inexorably, driven by another tsunami of bull speculation in bonds in which the big American and Japanese banks are calling the shots. Far from being able to control the situation, central banks are helpless. Their financial resources are no match for those of the bond speculators.

The only way to avert another tragedy is to stabilize the interest-rate structure. This the United States government could accomplish overnight, by opening the Mint to gold.

I. SPECULATIVE ORGY IN BONDS

Fly in the Ointment
There are two standard views of the Great Depression of the 1930's. Keynesians maintain that the capitalist system is, by its very nature, prone to overproduction and, in the absence of government intervention, excessive inventories will periodically lead to falling prices and to growing unemployment which will further compound the collapse in demand. They advocate public works financed, if need be, by massive deficit spending. The central bank must be instructed to buy up all the government bonds that the market is unwilling to absorb. According to the Keynesian view in the early 1930's the current economic fetish, the balanced budget, prevented an increase in public spending to boost demand. Thus, then, faulty fiscal policy is to be blamed for the economic collapse that followed. On the other hand Friedmanites maintain that, although the central bank should thrash out new money at a steady rate (something that in the words of Friedman "even a clever horse could be trained to do") the Federal Reserve was unable to learn this simple rule. It has been issuing money erratically, at times too much as in the stock-market frenzy of the 1920's; then again too little as after the stock-market collapse in the 1930's. In the latter episode the economy was squeezed through a shortage of money causing prices to fall. Thus, then, faulty monetary policy is to be blamed for the economic collapse that followed.

For some time it has been increasingly clear that both views fall short of the mark. The Friedmanites ignore the fact that while the central bank has power to issue all the money it wants at any rate of volume it wants through the instrumentality of open market purchases of bonds, yet it is utterly powerless to determine how the new money so created shall be used by market participants. Commodity speculation is not the only use to which newly created money can be put. Another possibility is bond speculation which instead of raising the prices of goods will raise the prices of bonds or, what is the same to say, will lower interest rates. Thus the sorcerer (the central bank) finds itself in competition with its apprentices (the bond speculators) and, of necessity, will lose control to them. On the other hand, the Keynesians ignore the fact that financing public works is a depressant on enterprising exuberance. Entrepreneurs are not prepared to compete unconditionally with the government for funds to finance projects. They want to be convinced that theirs will be profitable. Deficit spending by government brings profitability of the projects of private enterprise very much into question.

Although superficially these two approaches to the problem appear to argue from different angles, they are in fact the same, albeit in different disguise. Both the Keynesians and the Friedmanites advocate the application of the same nostrum: the monetization of government debt, for the same purpose: to suppress the rate of interest for political ends. But there is a fly in the ointment prescribed by quacks of either persuasion, namely, the bond speculator. The so-called fiscal and monetary stimulus to boost demand is a myth. Either stimulus rather than boosting demand for commodities shall only boost speculative demand for bonds. The bond speculator wants to buy first so that he can feed the bonds to the central bank at a hefty price advance when it is ready to enter the open market to buy its quota.

Loading the Dice
Here is the description of the process in more details. As the bond market is destabilized by the expulsion of gold and by the introduction of an extraneous demand for bonds for purposes other than saving (to wit, for political purposes) there will appear an increase in the volatility of bond prices, and a corresponding increase in the volatility of interest rates. Bond speculators, dormant while the interest-rate regime is stable as it is under a gold standard, will come to life with a vengeance as soon as volatility appears. Individual speculators as well as financial institutions will duly note that big money is to be made by trading (as opposed to holding) bonds. There is more. In the new casino (the bond market) the dice are loaded (the odds are stacked in favor of the bulls). Speculators armed with this intelligence can have a free ride to riches. They simply stick to the long side of the market. Since the central bank is a buyer virtually every time it enters the market, the risk inherent in trading bonds has by and large been eliminated. Speculators buy before the central bank does, and sell after. Little wonder that bond speculation has snowballed and become malignant, exceeding even the worst excesses of the earlier stock-market speculation.

Stabilizing or Destabilizing Speculation?
The insight that both the Keynesian and Friedmanite nostrums (allegedly suitable to prevent depressions) are counter-productive in that they aggravate rather than alleviate the crisis, has escaped mainstream economists. They accept the conventional wisdom that speculation tends to dampen volatility in any market. However, this generalization is patently false. One must distinguish between two kinds: stabilizing and destabilizing speculation according as it deals with risks created by nature, or risks created by man. The thesis that speculation will even out fluctuations is true only of the first variety, e.g., speculation in market for agricultural commodities. With regard to the second, speculation in markets dealing with risks created by man (including those created by governments), fluctuations will increase as a result of speculation. For example, in the bond market more speculation means more volatility, not less, as speculators seek to induce and ride price trends, rather than resisting them. They do not act randomly as speculators in the commodity markets do. Bond speculators march in lockstep.

The Rise in the Cost of Liquidating Liabilities
We shall see that bond speculation has a pivotal role in the genesis of depression and deflation. The buying of bonds for speculative purposes depresses interest rates from their true level. The mechanism that transmits the fall in the interest-rate structure to a fall in the commodity price structure is provided by the rising bond price. It makes the present value of total debt rise. As a rule of thumb, the present value of debt gets doubled every time the rate of interest gets halved. (For details, see my two papers Kondratieff Revisited and The Economic Consequences of Mr. Greenspan.) As the present value of debt rises, the cost of liquidating liabilities also rises. Here is the missing link mainstream economists have consistently ignore: the rise in the cost of liquidating liabilities causes an uncontrollable increase in the overall cost of servicing capital already deployed in production. As costs increase, profits fall. Thus the squeeze on profits is not caused by the falling price-structure as asserted by Keynesian orthodoxy. Falling prices are themselves an effect, not a cause. The real cause is the falling interest-rate structure revealing that productive capital has been financed at rates far too high. As a result of the squeeze profits are turned into losses. Many firms fail, taking others down with them in a domino-effect as receivables get harder to collect. Demand collapses, prices fall.

The central bank is desperately trying to apply damage-control by putting more money into circulation. However, the new money is just oil on the fire. It is not flowing to the commodity markets as expected. It flows to the bond market where the action is. Bidding for bonds in competition with speculators the central bank puts even more pressure on the rate of interest. The vicious circle is closed. The squeeze on profits is increased and more productive enterprise fails. Once Keynesian fiscal policy and/or Friedmanite monetary policy have become official, bond speculators face virtually no risk. Central bank intervention will provide a nice tail-wind to make their sails bulge.

Clandestine Wealth-Transfer
It is not hard to identify the chief culprit of bond speculation. It is the banking fraternity trying to rebuild bank capital that has been devastated during the preceding boom. The banks suffered huge losses in their bond portfolio thanks to the relentless rise in interest rates. Even greater losses were sustained in the investment portfolio due to the proliferation of non-performing loans, as their clients have become over-extended in the face of rising interest rates. Now the rate of interest is falling, and the banks once more have the upper hand. They are determined to make most of it.

The point is that the wealth of failing productive enterprise does not go up in smoke during the depression as suggested disingenuously by the Keynesians and the Friedmanites. It is being siphoned off and will show up as capital gains in the banks' bond portfolio. In this revisionist view the Great Depression appears to have been caused by a massive clandestine wealth-transfer from the productive sector to the financial sector, denuding the former of its capital. The wealth-transfer has been made possible in the first place by the destabilization of the interest-rate structure. For this the responsibility lies squarely with mistaken government policies caving in to anti-gold propaganda and agitation for unlimited deficit-spending.

Why Swissair has fallen out of the sky?
As an example of the clandestine wealth-transfer we may wish to scrutinize the example of the downfall of Swissair. It has been the envy of the airlines industry for half a century. It was well-capitalized and well-managed, with an increasing market-share and with an excellent record of paying dividends. No one could predict that it would be the first to fall out of the sky after September 11. How did it happen?

Swissair was a victim of the clandestine wealth-transfer plaguing the productive sector as a result of the falling interest-rate structure caused by bond speculation. The airlines industry is one of the most capital-intensive industries, which is especially vulnerable to concealed capital consumption through paying out phantom profits. The invisible erosion of the capital base of Swissair finally reached the point that it could no longer pay its bills after the contraction of the market and it folded. The shareholders' equity in the balance sheet of Swissair did not go up in smoke. It ended up in the balance sheet of the bond speculators as a capital gain.

This should be a warning to all firms engaged in productive enterprise. The same could also happen to them, regardless how well-managed or well-capitalized they may appear at the moment.

There is no protection against the vacuum-cleaner effect of bond speculation on their balance sheet if the interest-rate structure keeps falling.

Collapse of Demand or Collapse of Production?
In the second part of this essay we shall put the patience of the reader to test by a detour to discuss some fundamental book-keeping principles. This will be necessary for a full understanding of the stealthy wealth-transfer from the productive to the financial sector. The transfer would have never been possible had the balance sheets of individual firms in the productive sector shown the true financial picture at all times, and had the accounting profession raised the alarm about the ongoing capital consumption. But due to a relaxation of accounting standards to accommodate war-finances in 1914, the balance sheet ignored the huge increases in the cost of liquidating liabilities in the falling interest-rate environment. The accounting profession was in the dark and could not detect the ongoing destruction of capital. Worse still, phantom profits were being paid out that further ate into capital, ultimately leading to the downfall of the productive sector of the economy.

In the third part, out of these elements we construct the revisionist theory of the Great Depression and warn of the consequences of the present falling interest-rate environment in which the same forces are at work once more. We conclude that the causes of the Great Depression are found in the combination of three factors: (1) the fatally relaxed accounting standards, (2) the creation of the Federal Reserve banks in 1913, making the monetization of debt possible, and (3) the destruction of the gold standard in 1933. These three factors interacted to cause wholesale capital destruction in the productive sector. It was not the collapse in demand that caused the collapse of production, as asserted by the currently fashionable Keynesian and Friedmanite orthodoxy. It was the exact opposite: the collapse in production causing the collapse of demand. The collapse in production occurred in response to the invisible destruction of capital due to the falling interest-rate structure which, in turn, was engineered by the bond speculators, chief among them the banking fraternity.

Revisionist View of the Great Depression - Part II - BOOK-KEEPER'S DILEMMA


 

Author: Antal E. Fekete

Antal E. Fekete
Professor, Intermountain Institute of Science and Applied Mathematics, Missoula, MT 59806, U.S.A.

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