What Does Bernanke Really Know about the Great Depression?

Determined to make sure there will be no repeat of the 1930s depression, the Fed cut the funds rate to 1 percent, the lowest level since 2003-04. Moreover, from October 8 to 22, the Fed raised the monetary base from $984,375 billion to $114,749 billion, a 16 per cent increase in two weeks. Clearly Mr. Bernanke is a man of action. But is it the right action?

Bernanke is mesmerized by the tragedy of the 1930s. He does not want to go down in history as the central banker who caused a second Great Depression because he was too timid to act on monetary policy. Unfortunately, Mr. Bernanke does not know nearly as much about the 1920s and 1930s as he thinks he does. This is why he is unwittingly making things worse.

The most important thing to keep in mind is that the Great Depression was the product of a monetary disorder that had its roots in the early 1920s. Now one cannot really talk about this unless two fundamental facts are always kept in the foreground: Fact one is that money is not neutral. By this it is meant that increasing the money supply will influence individual prices and so distort the price structure. Some 200 years ago, Lord King explained that the monetary effect on prices is not equal and is therefore

...not produced immediately upon the issuing of the notes, and some time must elapse before the new currency can circulate through the community and affect the prices of all commodities. It is this interval between the creation of the new paper and the rise of prices which may be a source of advantage to the persons who obtain loans from the Bank. The merchant, to whom the notes are immediately issued, employs them in the purchase of goods at the prices which they then bear, or is enabled by the payment of a former debt to obtain credit for them at those prices. (Lord Peter King, A Selection from the Speeches and Writings of the Late Lord King, Longman, Brown, Green, and Longmans, 1844 p. 85).

By distorting prices, including interest, the most important of all prices, monetary expansion distorts the capital structure and creates malinvestments that will eventually reveal themselves in the form of idle capital once the boom reaches its final phase. It follows that injecting more money into the economy to counter the consequences of the previous injections merely makes matters worse.

This brings us to the second fundamental fact: any attempt to maintain a stable price level must eventually result in a recession for reasons already outlined. In response to the erroneous view that a stable price level is essential if the public's demand for money is to be satisfied, the brilliant Lord King responded with the observation that

It is manifest . . . that the proportion of circulating medium required in any given state of wealth and industry is not a fixed, but a fluctuating and uncertain quantity; which depends in each case upon a great variety of circumstances, and which is diminished or increased by the greater or less degree of security, of enterprise and of commercial improvement. The causes which influence the demand are evidently too complicated to admit of the quantity being ascertained by previous computation or by any process of theory. (Ibid. p. 67).

One of the problems we face today is that the vast majority of economists cannot distinguish between a monetary induced fall in prices and productivity induced fall. The first phenomenon is deflation, i.e., a monetary contraction. The second phenomenon is the result of falling costs brought about by more investment in the material means of production. By preventing the market from allowing the fruits of increased productivity to be reflected in falling prices and hence a rise in real incomes, economic policy has served to skew the pattern of incomes in a way that is detrimental to the economic welfare of a great many wage earners.

This is what happened during the 1920s. The latter half of the nineteenth century demonstrated that falling prices, economic growth and expanding job markets are perfectly compatible. Milton Friedman — a great defender of the stable price level fallacy — was forced to admit this when he observed that after the Civil War

[T]he price level fell to half its initial level in the course of less than fifteen years and, at the same time, economic growth proceeded at a rapid rate. The one phenomenon was the seedbed of controversy about monetary arrangements that was destined to plague the following decades; the other was a vigorous stage in the continued economic expansion that was destined to raise the United states to the first rank among the nations of the world. And their coincidence casts serious doubts on the validity of the now widely held view that secular price deflation and rapid economic growth are incompatible. (Milton Friedman and Anna J. Schwartz, A Monetary History of the United States 1867–1960, Princeton, N.J.: Princeton University Press, 1971).

Pushing on a piece of string might sound apt, but it really is a grossly misleading analogy. The reason why low interest rates in the 1930s failed to stimulate investment and so raise the demand for labor is that Hoover and Roosevelt's economic policies crushed profits. No businessman will borrow money if he cannot make enough to pay off the loan. Punishing business is no way to encourage investment and raise the real demand for labour. But this is precisely what Hoover and Roosevelt did. And both of them remained stubbornly oblivious to the social, political and economic consequences of their destructive actions.

Hoover's policy of holding wage rates above their market clearing levels caused unemployment to soar. In 1929 the two-way division between employees and corporations was 81.6 per cent and 18.4 per cent respectively. In 1933, employees' share had rocketed to 99.4 per cent, payrolls fell from $32.3 billion to $16.7 billion and unemployment rose to a horrifying 25 per cent. Roosevelt and his advisors did not learn a damn thing from Hoover's misguided policies and so kept the economy thoroughly depressed until Hirohito and Hitler restored full employment.

I'm afraid Mr. Bernanke will go to his grave completely unaware of what really happened in the 1920s and 1930s. When Greenspan began to expand the money supply to drag the economy out of the recession that the Bush administration had inherited, I remarked at the time that he was laying down the foundations for another recession (The US economy and Alan Greenspan: what is going wrong?). Well, his recession arrived on schedule.

Comments

[apppro:]

<<What Does Bernanke Really Know about the Great Depression?>>

Squat!!!!!!!!!!!!!!!!

2008 Nov 04 08:02 AM

[1worldcurrency:]

It's not what you don't know that kills you, it's what you think you know but can't possibly.

2008 Nov 04 08:10 AM

[Alan von Al...:]

Thank you, Mr. Jackson. I hope it's some comfort to know that your work is much needed and read eagerly on this forum. A question, please. Assume further quantitative easing, perhaps a big program of fiscal stimulus and higher taxes (which I and many others expect), can you project a result in 2009, 2010, etc? Practical giudance is extremely valuable.

2008 Nov 04 08:28 AM

[bluhorseshew:]

Let me get this straight. You are genuinely putting your opinion, the academic basis for which you omitted in the article, against that of an individual who has arguably done more study on the topic than just about anyone else on the planet. Please don't deceive yourself into believing that pulling a few quotes from noted economists and pushing that circular information into your square hole somehow provides you intellectual merit. The clearest bit of information to be gleaned from the superfluous drivel you are trying to pass off as academia is that you truly don't understand the depth of issue at hand. Your willingness to display your lack of understanding is, shall we say, amusing.

2008 Nov 04 08:36 AM

[deebee9:]

Bravo, Mr. Jackson. It's remarkable how many modern economists seem to know nothing of King, Bastiat, or even Mises. It's encouraging to know that you do!

2008 Nov 04 08:43 AM

[investor88:]

Seems a good article; I say seems because it is rather abstract to me but seems to make sense. Will read again to get better traction.

2008 Nov 04 08:48 AM

[Asbytec:]

I am of the opinion our economy is so skewed by heavy debt, trade imbalances, fiat currency, and unlimited money supply, no theory has yet been devised to explain our current situation.

Many things can cause a great depression, and our current situation is one. I've argued we might even need one. We certainly could use an economic reboot and get back to a strong currency and sustainable growth.

"Post industrial economy" my butt. Paper, its paper...we need industry and jobs. Period.

2008 Nov 04 09:04 AM

[prudentinve...:]

Excellent article. I wish policymakers would read and understand it.

2008 Nov 04 09:19 AM

[Asbytec:]

And, if you want to point fingers, yes, Greenspan...not Bernanke. Alan bailed on time and at the peak of his popularity, as did most of the wall street giant CEOs. They're gone, sailing the Med. Bernanke, et al, were left holding the proverbial bag of you know what.

2008 Nov 04 09:24 AM

[axelrod608:]

Excelent article and long overdue. The current reigning economic theory has more holes than fine swiss cheese, yet the talking heads believe it as a matter of faith. A couple observations -

First, on the wage issue income has gotten so skewed to the top 1% that much of the nation's income never makes it to the "main street" economy. And that economy is what keeps the national economy - the one in the streets of America - humming. The wealthy are pouring money into "investments", mostly PAPER not manufacturing. That money never makes it to the source of the "trickle-down" that, in theory only, is supposed to flow down to the proles.

Second, what the infusions of government funds does to a business depends largely on sentiment. In good times, that money would be quickly reinvested. Currently, where exactly is the money to be reinvested ? The opportunities aren't out there and fear is holding back investment. One place the new money is going is to buy up other failing businesses which ALWAYS ends up swelling the ranks of the unmployed. Every merger results in job cuts. See #1 for the result to the "main street" economy.

Third, historically rich companies and industries get fat. The salaries and wages grow and when hard times arrive, the personnel costs are unsustainable. That is precisely the condition of the American auto industry. If all salaries and wages were cut by, say, 50%, EVERY employee would keep their job and the companies would make money. Before pouring a bunch of federal money into an unsustainable sector, it would be interesting to see just how profitable the auto industry could be at half the personnel cost. Ultimately, it is a choce between earning unsustainably high wages or not working. So far, the white and blue collar auto workers are choosing "not work".

Finally, for Bernanke to believe in parallels between the 1920's and 1930's with today is just plain silly. With a few strokes of a computer, today one can "create" a trillion dollars or change interest rates to any number one chooses. But unlike former times, individuals, companies and governments are drowning in a tsunami of debt. They need more credit and debt like a fish needs a bicycle.

All Bernanke and his buddy Paulson are doing is replacing money lost by inept, greedy, incompetent corporate gamblers with tax revenues. We have an enormous, overgrown, overpaid financial sector. It is unsustainable. The efforts to reinflate the credit bubble with yet more cheap credit will fail. Or worse, they will succeed and when the bubble pops the second time, all will be lost.

2008 Nov 04 09:29 AM

[SW Richmond:]

"What Does Bernanke Really Know about the Great Depression?"

His answer is this, from his 2002 paper: "The logic of the printing press must assert itself."

Or so he thinks.

2008 Nov 04 09:37 AM

[Jason Rines...:]

I liked the historic references as well. The Fed cannot fix this problem, Congress must and I am not a big fan of this current crop that will largely remain in power this election. Here is the best salient point of the article for me:

"Roosevelt and his advisors did not learn a damn thing from Hoover's misguided policies and so kept the economy thoroughly depressed until Hirohito and Hitler restored full employment."

To restore the economy, wages must rise to pay off a heavy debt load and spur savings to reinvest. As noted in the article, manipulations to freeze or increase wages create horrific unemployment. Job creation policy on the other hand on a broad scale for energy, manufacturing, technology, upward mobility in other words is what works. Consider that it was not simply the wartimes jobs created that restored America, but the innovations that came out of it that stuck as new industries, jet power, nuclear power, mainframe computing, etc etc.

Bernanke seems to be trying what was not tried during the Great Depression. Fighting deflation is a losing battle and simply stifles a correction process that must continue. None of us will probably ever really know in the end how effective or how much pain was spared or created.

The time to 'change' course on monetary policy and make serious adjustments to spur innovation was 2005. But the private market didn't do this either, way too much liquidity and profits shuffling paper in financial innovation. Understandable to some degree (minus the fraud of course) but regrettable.

2008 Nov 04 09:42 AM

[sickofthehype:]

Bottom line - Nobody knows the exact outcome, otherwise they'd be rich and living on their own island somewhere.

There's points to be made by both inflationary and deflationary camps, but the end result - down the road - sooner or later - will be inflation. Simply because what's going on is an inflationary campaign.

2008 Nov 04 09:44 AM

[Jason Rines...:]

Well put Axelrod. I always enjoy your comments.


On Nov 04 09:29 AM axelrod608 wrote:

> Excelent article and long overdue. The current reigning economic
> theory has more holes than fine swiss cheese, yet the talking heads
> believe it as a matter of faith. A couple observations -
>
> First, on the wage issue income has gotten so skewed to the top 1%
> that much of the nation's income never makes it to the "main street"
> economy. And that economy is what keeps the national economy - the
> one in the streets of America - humming. The wealthy are pouring
> money into "investments"... mostly PAPER not manufacturing. That
> money never makes it to the source of the "trickle-down&amp;...
> that, in theory only, is supposed to flow down to the proles. <br/>
>
> Second, what the infusions of government funds does to a business
> depends largely on sentiment. In good times, that money would be
> quickly reinvested. Currently, where exactly is the money to be reinvested
> ? The opportunities aren't out there and fear is holding back investment.
> One place the new money is going is to buy up other failing businesses
> which ALWAYS ends up swelling the ranks of the unmployed. Every merger
> results in job cuts. See #1 for the result to the "main street" economy.
>
>
> Third, historically rich companies and industries get fat. The salaries
> and wages grow and when hard times arrive, the personnel costs are
> unsustainable. That is precisely the condition of the American auto
> industry. If all salaries and wages were cut by, say, 50%, EVERY
> employee would keep their job and the companies would make money.
> Before pouring a bunch of federal money into an unsustainable sector,
> it would be interesting to see just how profitable the auto industry
> could be at half the personnel cost. Ultimately, it is a choce between
> earning unsustainably high wages or not working. So far, the white
> and blue collar auto workers are choosing "not work".
>
> Finally, for Bernanke to believe in parallels between the 1920's
> and 1930's with today is just plain silly. With a few strokes of
> a computer, today one can "create" a trillion dollars or change interest
> rates to any number one chooses. But unlike former times, individuals,
> companies and governments are drowning in a tsunami of debt. They
> need more credit and debt like a fish needs a bicycle.
>
> All Bernanke and his buddy Paulson are doing is replacing money lost
> by inept, greedy, incompetent corporate gamblers with tax revenues.
> We have an enormous, overgrown, overpaid financial sector. It is
> unsustainable. The efforts to reinflate the credit bubble with yet
> more cheap credit will fail. Or worse, they will succeed and when
> the bubble pops the second time, all will be lost.
>

2008 Nov 04 09:55 AM

[NJ Craig:]

The great depression simply was caused by an extended imbalance between supply and demand. Henry Ford et al greatly increased productivity. And supply skyrocketed. Demand did not change at the same rate resulting in the imbalance. The depression came about 10 years later. The depression ended with supply being bombed to pieces during WW II.

This time, Bill Gates increased productivity dramatically. And, due in part to age demographics, demand has not increased. In addition, China and India, thanks in part to Gates, have increased their productive capacity. About ten years later, supply is not in balance with demand and won't be until ... . Until supply decreases due to plague or war or demand increases. America (and the rest of the developed world) has maxed out it's Amex card; so the only place demand can increase is in developing countries.

The good option is for this "recession" ending when India or China or the Middle East become net importers. The bad option is for supply to be crushed by pestilence or war.

2008 Nov 04 10:55 AM

[derryl:]

axelrod is right. There have been massive and illegitimate misallocations of money.

Wall St investment banks are a "shadow banking" system that is allowed to create money just like the real banking system creates money. But the real banking system creates money to finance the real economy, and investment banks create money to shuffle the ownership of paper.

Unfortunately the paper values generated by Wall St magic money are allowed to compete with real bank dollars in the real economy via the "incomes" paid to investment bank management and workers and shareholders. They create and pay themselves billions of imaginary dollars without producing a single item of real worth. And whatever real capital is locked up in investment bank shares is not available for investments in the real economy via the stock markets or other mediums.

This creates a massive misallocation of real wealth and real investment. It starves workers in the real economy to reward magicians in the shadow economy.

So on the one hand we have way too much "money" in the system that was generated by shadow banking. And on the other hand we have the people who need that money to pay their mortgages and bills unable to access it.

It is the ownership of the money that has been misallocated by shadow banking. It put way too much money in way too few hands. It didn't do this by producing anything. It did it by magic. The shadow banking system has not "earned" any money. It just created money out of nothing and spent it into YOUR economy as if it was real bank money.

This does not address the other problem that too many people bought houses that they could not economically afford to own: this was a misallocation of real resources (houses) caused by government housing policy and administered by the real banking system. Dealing with this problem is a separate issue.

But the immediate issue is how to wind down the shadow banking industry without throwing the real economy into depression. This must involve the dissolution of shadow bank dollars created by 30:1 asset/capital ratios in the shadow banking industry. And it must involve reallocation of the ownership of money that is currently owned by the "wrong" people who did nothing to earn it.

Since this magic money was sold across the planet this has become a global financial problem. Let's hope the G50 meeting in Davos on the 15th recognizes the cause of this problem so they can come up with a realistic course of action to fix it.

So let's give Mr. Jackson credit for observing that we do ourselves no favor by overtaxing real economy corporations and slandering real economy banks. These are the producers of real wealth who we work for and buy stuff from. We need to support them, not attack and diminish them.

Direct the taxes instead at the shadow economy. This will deflate the prices of $20 million NY penthouses and $200 restaurant meals but will have almost no effect on the broader US economy. It will probably be beneficial.

2008 Nov 04 12:54 PM

[woodsey:]

Mr. Jackson, very thoughtful article. I don't agree with much. About the GD, been there and done that. The common people handled it well. One of the worst things was the f'n government STOLE the common people's gold. The worst thing you have done is use Mr. Bernanke for a straw man. To deflect away from yourself ?

2008 Nov 04 06:13 PM

[Jason Rines...:]

Derryl, you have really hit a home run with that comment of truth. To finger those at the top of the shadow banking system that could be identified and implicated, implicates major politicians so it will not happen anytime soon.

To be sure, there will be justice at some point. Unfortunately the biggest global swindle in history will be paid for by the American public. On top of a necessary painful return to Save and Invest economy, the bankers that purpetrated this swindle added a very nasty twist to the tail. Truly heinous but reality. The shadow banking system is being delevered and dismantled piece by piece with a loss somewhere in the real economy of course.


On Nov 04 12:54 PM derryl wrote:

> axelrod is right. There have been massive and illegitimate misallocations
> of money.
>
> Wall St investment banks are a "shadow banking" system that is allowed
> to create money just like the real banking system creates money.
> But the real banking system creates money to finance the real economy,
> and investment banks create money to shuffle the ownership of paper.
>
>
> Unfortunately the paper values generated by Wall St magic money are
> allowed to compete with real bank dollars in the real economy via
> the "incomes" paid to investment bank management and workers and
> shareholders. They create and pay themselves billions of imaginary
> dollars without producing a single item of real worth. And whatever
> real capital is locked up in investment bank shares is not available
> for investments in the real economy via the stock markets or other
> mediums.
>
> This creates a massive misallocation of real wealth and real investment.
> It starves workers in the real economy to reward magicians in the
> shadow economy.
>
> So on the one hand we have way too much "money" in the system that
> was generated by shadow banking. And on the other hand we have the
> people who need that money to pay their mortgages and bills unable
> to access it.
>
> It is the ownership of the money that has been misallocated by shadow
> banking. It put way too much money in way too few hands. It didn't
> do this by producing anything. It did it by magic. The shadow banking
> system has not "earned" any money. It just created money out of nothing
> and spent it into YOUR economy as if it was real bank money.
>
> This does not address the other problem that too many people bought
> houses that they could not economically afford to own: this was a
> misallocation of real resources (houses) caused by government housing
> policy and administered by the real banking system. Dealing with
> this problem is a separate issue.
>
> But the immediate issue is how to wind down the shadow banking industry
> without throwing the real economy into depression. This must involve
> the dissolution of shadow bank dollars created by 30:1 asset/capital
> ratios in the shadow banking industry. And it must involve reallocation
> of the ownership of money that is currently owned by the "wrong"
> people who did nothing to earn it.
>
> Since this magic money was sold across the planet this has become
> a global financial problem. Let's hope the G50 meeting in Davos on
> the 15th recognizes the cause of this problem so they can come up
> with a realistic course of action to fix it.
>
> So let's give Mr. Jackson credit for observing that we do ourselves
> no favor by overtaxing real economy corporations and slandering real
> economy banks. These are the producers of real wealth who we work
> for and buy stuff from. We need to support them, not attack and diminish
> them.
>
> Direct the taxes instead at the shadow economy. This will deflate
> the prices of $20 million NY penthouses and $200 restaurant meals
> but will have almost no effect on the broader US economy. It will
> probably be beneficial.
>

2008 Nov 04 07:10 PM

[flow5:]

Hoover & Roosevelt both ran on balanced budgets.

2008 Nov 05 03:00 PM

[flow5:]

I don't think BERNANKE understood the Great Depression. But it is obvious from the FED's "tools" that he copied the concept of the liqudity facilities directly from GREAT DEPRESSION monetary policies.

The facts are that the FED’s structural problems caused excess reserves to be quickly wiped out by the massive “runs” on the banks. I.e, the FED couldn’t expand the money supply - even if there weren’t any panic stricken “runs” on the banks. To say that the money supply declined is to ignore the real source of the problem.

As if failing to make the Federal Reserve a universal system was not enough of a handicap to effective monetary management, the Congress created twelve Federal Reserve Banks. I was not until 1933 that legislation was passed enabling the open market operations of the various banks to be coordinated. I.e, before 1933 one FRB could be expanding credit, creating bank reserves and laying the foundation for a multiple expansion of money, while another FRB was doing the opposite. Since 1933, all open market operations of the twelve FRB are executed through the manager of the open market account in the FRB of New York (our central bank).

From 1933-1942 the centralization of the open market power was of little consequnce. So pervasive was the trauma of the Great Depression, and the lack of what the banks considered “bankable loans”, expansion of reserve bank credit typically led to more excess reserves rather than more loans, and money.

At the onset of the Great Depression, Federal Reserve Notes had to have a MINIMUM backing of 40 percent “eligible paper” and a MAXIMUM backing of 60 percent “eligible paper”

In 1933 the Federal Reserve Note had to be collateralized by a least 40 percent in gold bullion or coin, and the remaining collateral had to consist of "eligible" commercial paper, principally Trade and Banker's Acceptances. The FED neither had sufficient gold nor the banks sufficient discountable “eligible paper” to meet the panic-inspired massive demands of the public for currency.

Hence, bank failures were more than numerous; they would have been virtually universal if Roosevelt had not declared a “bank holiday” in March, 1933.

It was not until 1933 that we began to unshackle our paper money from the numerous and unnecessary restrictions pertaining to its issuance. With the numerous types of paper money in circulation at the time, this would seem to have been a nonproblem. Here is the list: gold certificates, silver certificates, National Bank notes, United States notes, Treasury notes of 1980, Federal Reserve Bank notes, and Federal Reserve notes.

With that array of paper money there should have been plenty to meet the liquidity demands placed on the banks by the public. But the volume of each type that could bde issued was so circumscribed by restrictions that even the aggregate group could not begin to meet the panic demands of the public.

One of the pre-conditions the U.S. needed in 1929, was a much larger national debt, and a willingness on the part of the Congress, the Administration, and the business communty to tolerate an adequate expansion of the national debt. In 1929 the national debt was less than $17 billion, and the banks held only a SMALL proportion of that amount. We needed a larger debt and a much more rapidly expanding debt in the 1930's, not only to "prime-the-pump", but to meet the monetary management needs of the FED.

The open market operations of the FED require a depth of market that will enable the FED to buy or sell billions of dollars worth of treasury bills on any given day without deeply disturbing the bill rates.

After 1933, after we had central bank and a coordinated FED credit policy, the FED pumped billiins of dollars of reserves iinto the banks; and nothing happened. There were years during this period when the excess legal reserves held by the member banks were larger than the volume of required reserves. The exercise of FED policy was likened "to pushing on a string". It was true, as the Keynesians insisted, that monetary policy didn't matter; fiscal policy was everything.

Today the Federal Reserve Note has no legal reserve requirements, and the capacity of the FED to create IBDDs (interbank demand deposits) has no legal limit.

There is only one restriction placed upon its isssuance. No Federal Reserve Note can be put into circulation unless there is a prior transaction involving the relinquishing by the public of an equal volume of bank deposits, and an equal diminution of holdings of IBDDs on deposit with the Federal Reserve District banks. In other words, the issuance of our paper money contains no inflationary bias. Its issuance does not increase the volume of money. It merely substitutes one form of money for another form.

2008 Nov 05 03:06 PM