US Financial Markets Rocked -- What is Really Happening
Last week I alerted readers to the possibility of a cut in the Fed funds rate. As sure as God made little apples, a cut is exactly what we got -- except that it was the discount rate that was cut. For those of you who gave a sigh of relief at the Fed's "timely intervention": take a deep breath because at some time in the future we will get a rerun of this financial fiasco and the Fed won't be able to stop it without igniting a severe inflation. Assuming for a moment that the Fed took this risk, the result in all likelihood would be a run on the dollar followed by an immediate increase in the funds rate on the heels of which would emerge an unavoidable recession.
The frustrating thing about writing this stuff is the knowledge that we have been here before. In fact, these kinds financial panics plagued the UK in the first part of the nineteenth-century, which in turn gave rise to Marx's nonsensensical theory of the "business cycle". (The truth be told, Marx's basic 'understanding' of the economic forces that brought on depressions was no better than John Stuart Mill's, whose 'theory' Marx was forced to turn to for support. The world would have been a much better place if Ricardo's insight into this particular phenomenon had not been forgotten).
Anyone who takes economic history seriously knows that these financial upheavals did not stop in 1850. Unfortunately, very few people know that the same thing happened during the 1920s and for three fundamental reasons. Those reasons being the belief
that monetary expansion does not affect individual prices, at least to any significant degree
that capital is a homogeneous fund whose shape cannot be changed by changes in the money supply
that the fed can safely control the rate of interest and hence the 'price level'
Therefore to understand the economic events of the 1920s is to understand what is happening today. So let us begin with the 1920-21 financial crisis that was quickly followed by a boom. But in 1923 the economy started to experience a mild turndown which continued into 1924. To reverse this trend the Fed stepped on the monetary accelerator and the money supply rose by 11 per cent from the middle of 1923 to December 1924. During the same period the New York City prime commercial rate fell from 5 per cent to 3.6 per cent, the call rate went from 5 per cent to 3.5 per cent while the fed's discount rate dropped from 4.5 per cent (it had been 4 per cent in June 1922) to 3 per cent. (All of this should begin to look eerily familiar by now).
As one would expect the monetary expansion (what is euphemistically called liquidity today) started the economy booming again, along with the stock market. However, the inflow of gold was reversed and the economy suffered a gold drain. (This should have alerted the fed to the fact that inflation was intensifying despite the 'stable price level'). But the effects of a monetary injection last only so long, leaving in its wake financial and real imbalances in the economy that will eventually have to be confronted. In 1926 the economy once again started to slow as the effects of the previous monetary injection worked their way out. The money supply stood at about $43 billion in December 1926, the New York City prime commercial rate had risen to 4.5 per cent , the call rate was 5.2 per cent and the Fed's discount rate was now 4 per cent. The Fed then acted the way every good central banker is supposed to act, meaning that once again it opened the monetary tap.
In June 1927 the money supply was about $44 billion. By December it had risen by about 3.5 per cent, an annual average of 7 per cent. The Fed's discount rate was now down to 3.5 per cent and the New York City prime rate had fallen to 4 per cent.. However, the call rate scarcely moved. Between June 1927 and December 1928 the money supply grew by about 7 per cent. It was at this point that the Fed slammed on the monetary brakes, after which the money supply fell slightly until December 1929, after which a severe deflation set in.
So how did the stock market boom throughout 1928 if monetary growth had stopped? Well, as Benjamin M. Anderson pointed out, so much money had been created there was still plenty of it sloshing around during 1929. There was also the Fed's mistake in making itself the primary market for acceptances which helped continue the share market boom. Naturally, booming share prices encouraged even more share issues. Human ingenuity being what it is enormous amounts of loans were made with very little money. As Fritz Machlup said: "...one dollar is capable of creating many dollars worth of brokers' loans". (The Stock Market, Credit and Capital Formation, William Hodge and Company, Limited, 1940, p. 122)
Money lies at the heart of every financial crisis. Yet money, particularly in the form of credit expansion, is the one thing that is not mentioned. That the policy of "pumping liquidity into the financial system" is the same policy that caused the crisis in the first place is a thought so distant from modern economics that it never enters the collective head of our economic commentariat. And the same goes for Australia where -- believe it or not -- the situation is even worse. I have yet to meet an economist down here who can even tell me the fundamental differences between the currency school and the banking school. Not one even knows anything about the bullion controversy of the early nineteenth century.
These subjects are not arcane topics from the history of economic thought. They are crucial to our understanding of what is happening today.
There is a myth that no one foresaw a crash. In fact, Roger Babson, a Boston financial adviser, was warning investors in September 1929 of an imminent crash. Then there were the sound E. C. Harwood and Benjamin M. Anderson who also warned that a crash was unavoidable. There was also von Hayek and von Mises along with Felix Somary, a Swiss banker, who also warned about the economic storm that was bearing down on the country.
*Money supply defined as currency outside the banks and all bank deposits.