1913: The Origin of This Whole Mess

Part I

Economists disagree on the identity of the true culprit behind our current crisis. Some blame Wall Street; some blame the progressive politics that pushed Freddie Mac and Fannie Mae beyond their capacity; some blame the profiteering loan brokers, the foxy house flippers, and the naive subprime home buyers in their rush for quick profits. Some blame the Federal Reserve, including me from time to time.

In reality, all of the above had their role, but they are just players in a game, the rules of which are defined by politicians. The origin of the problem lies in the rule changes that caused the demise of sound commercial banking back in 1913.

Before then, good commercial banking had been functioning well, both in England and in the U.S., for about a century. Business cycle fluctuations, although sometimes painful, managed to keep the profession on the right track. The invention of the Fed in 1913 was supposed to allow banks to weather business cycle downturns without going completely bust because of irrational panic withdrawals that had no justification in the real data.

Morphing onto a national stage out of private banking functions already in development, the Fed's check clearing services and temporary commercial loan facilities were indeed a clever and useful idea. But the politicians discovered that, once the Fed found it could take over the centralized monopoly of legal tender issuance and then credit creation, it could be used for other things than just stabilizing the banking system. And everyone believed the Fed could control this new-found usage and that it would not do any harm.

In preparation for WWI, the government turned to the Fed credit-creation facilities to finance the war. It was a great success. The Fed managed to wrest most of the genie back into the bottle after the war by early 1920; but the temptation was too great and the discipline and privations too onerous, so they allowed over-issuance of credit to continue, ostensibly to help the country out of the recession the war disruption had caused.

The downturn ended in 1921; but the credit issuance continued. The result was 1929. As Doug Noland says in this week's article at Prudent Bear:

It was understood at the time [during the Great Depression] that our fledgling central bank had played an activist role in fueling and prolonging the twenties boom - that presaged The Great Unwind. Along the way, this critical analysis was killed and buried without a headstone.

How true. Very few economists today remember the Fed's role in inflating credit previous to the Depression. On the contrary, everyone, from Keynes to Friedman to Bernanke, believed and continue to believe to this day that the problem lay in too little credit.

Many base their hypothesis that the Fed did not over-expand credit in the 1920s on the fact that the price level was relatively stable. Economist Edward C. Harwood pointed out in published articles that an economy can present over-expansion of the money supply even in a climate of stable prices; and furthermore, that this held true in the 1920s. Outside factors can cause real prices to fall, while an excess of money supply camouflages these factors by keeping prices at the higher level, with no one the wiser.

Furthermore, what these theorists ignore entirely is that the Fed's newly assumed power to unleash the credit genie destroyed sound commercial banking in pretty short order. ("Power tends to corrupt; absolute power corrupts absolutely." Lord Acton)

In an unpublished article written around May of 1928, Harwood described the process by which the art of commercial banking became tainted and was eventually lost. He compared it to a play in three acts. After describing the players and the events of the first two acts, he wrote:

To date [May 1928], recent business history has paralleled acts one and two of this drama of commerce. Act III remains to be played. Just when it will begin is a problem, but it is certain that the actors will not fail to appear. It must be confessed that this drama is a tragedy. The third act may be readily imagined by those who have seen depression before. It is unfortunate that this is what we must expect, but such will always be the price of inflation.

He correctly predicted the depression that came one year later. He is one of the few, unfortunately forgotten today.

In the next parts of this blog post, I will go into the details of sound commercial banking, how it was allowed to self-destruct by the creation of the Federal Reserve, and how its destruction led to today's crisis.

Comments

[robert99:]

Do you have a link to Harwood's article?

I look forward to reading your next post.

Mar 25 08:45 AM

[john s. gordon:]

you say that credit issuance by the fed caused 1929, but there is more to it than that.
in 1920 most of the countries in the world owed us money from 4 yrs of war loans. good times continued in the 1920's as france, england, finland, ... proceeded with loan payments. however a dark cloud loomed in 1927 as agricultural commodity prices collapsed (the war ravaged nations of europe were finally able to feed themselves). nobody paid attention to the warning & speculative stock activity continued on wall st with 90/10 leverage. in 1930 after collapse of the creditanstalt invienna & succeeding events, england/france wer no longer able to make payments, the principal sources of cash influx to the u.s economy had gone away.
> jack

Mar 25 09:14 AM

[sunnsea:]

You are also forgetting the income tax cuts in 1924 on the wealthest individuals. This is always a sure fire way to start an asset bubble. And always overlooked by classically trained U.S. economists in any era.

Mar 25 09:32 AM

[martyg:]

allowing banks to become stockbrokers and stockbrokers to become banks seems to have turned into a very bad practice.

prior to recent times, a company such as goldman sachs, had to stay as a stockbroker, not a bank. the marriage between the different financial properties has become incestuous.

Mar 25 10:10 AM

[martyg:]

allowing banks to become stockbrokers and stockbrokers to become banks seems to have turned into a very bad practice.

prior to recent times, a company such as goldman sachs, had to stay as a stockbroker, not a bank. the marriage between the different financial properties has become incestuous.

Mar 25 10:11 AM

[Allan Frain:]

Agreed. Any real fix must address this overriding issue. Fractional reserve fiat taken to excess cannot be corrected by more of the same, which unfortunately is the policy course we are on.

Mar 25 10:26 AM

[kelm:]

The Federal Reserve has enormous power. It would be rare in human experience for an organization imbued with such power to not use it extensively over time and indeed, that is what we are seeing. There is a hubristic quality to what the Fed is doing - believing they can massively inflate the money supply yet stop inflation on a dime when it picks up. That same hubris existed in 1913 when a top British banker declared that a general war in Europe was impossible as their economies were too entwined and inter-dependent.

I look forward to the next article in the series.

Mar 25 11:05 AM

[Mr. Fusion,:]

"How true. Very few economists today remember the Fed's role in inflating credit previous to the Depression. On the contrary, everyone, from Keynes to Friedman to Bernanke, believed and continue to believe to this day that the problem lay in too little credit."

The author confuses two time periods. Before the crash, credit was too easy. Stocks were being purchased on margins of 10%. After the crash, companies could not find credit for their day to day operations.

Gee, that all sounds so similar to today's problems.

When the economy needed credit, after the crash, there wasn't enough. THAT is why economists blame the lack of credit for the Depression.

Mar 25 11:14 AM

[silverfox:]

keep in mind that a lack of credit is the direct result of a lack of Bank liquidity as a result of loan defaults.

On Mar 25 11:14 AM Mr. Fusion, wrote:

> "How true. Very few economists today remember the Fed's role in inflating
> credit previous to the Depression. On the contrary, everyone, from
> Keynes to Friedman to Bernanke, believed and continue to believe
> to this day that the problem lay in too little credit."
>
> The author confuses two time periods. Before the crash, credit was
> too easy. Stocks were being purchased on margins of 10%. After the
> crash, companies could not find credit for their day to day operations.
>
>
> Gee, that all sounds so similar to today's problems.
>
> When the economy needed credit, after the crash, there wasn't enough.
> THAT is why economists blame the lack of credit for the Depression.

Mar 25 11:44 AM

[john s. gordon:]

marty -

you are describing the need to reinstate glass-steagal - pronto.
> jack

Mar 25 12:31 PM

[fireball:]

"first by expansion, then by cotraction"
silver certificates, greenbacks, united states notes. collectable, rare.
wasn't the fed sold as an institution to avoid depressions and recessions? while allowing normal corrections and adjustments? hasn't really worked out so well.
at one time i owned stock in a small community bank. it paid generous dividends and split often. it was bought by a bigger bank which was bought by a bigger bank which was bought by a bigger bank which was bought by a bigger bank. each time this seemed a good thing. glad and lucky i sold when i did.
larry burkette was an ex-reformed-banker who called it a liscence to steal. how much is greed and how much is govt. meddling that allows this model to fail?
if you buy a home with a loan. the bank enters in a ledger money it never had. if you pay and default at the end of your loan the bank recieved close to triple the value of the origional loan and the real asset of property and home.
how can i buy shares in the federal reserve?
katy once again thank you for another article.

Mar 25 12:39 PM

[fireball:]

john s. gordon
great note about foriegn loans. from what i can find govt. (not only ours) bad loans are playing a huge role in this huge problem. it has been difficult for me (amatuer poking around) to come up with a lot but much of the bad debt that has been rebundled and sold may be trackable to foolish govt. loans. any ideas on that? i mean this time, round 2.
good note on glass-steagal too.

Mar 25 12:51 PM

[Gedankonomist:]

If it makes you feel any better, 1913 was also the "birth year" of the 16th and 17th Amendments. The former bestowed upon us the IRS and the latter, diminishing of state's rights all in the name of "democracy."

If you want to know what "democracy" really is, you can read the Federalist Papers, or if you want to know more quickly, read the "Communist Manifesto."

Mar 25 01:07 PM

[B. Johnson:]

People evidently don't understand the political civil war that's been going on between the federal and state governments, a political war that's been going on since the Constitution was drafted. The constitutionally unauthorized Federal Reserve is evidence of this. The reason for this war is that big-government factions have been looking for ways to knock down constitutional limits on federal government powers and spending since the Washington administration. And given that people at large evidently don't know the Constitution and its history, big-government factions have been getting away with usurping state powers.

In fact, given that the Founders made the 10th A. to reserve the lion's share of government powers to the states, not the Oval Office and Congress, Chief Justice Marshall had established the following case precedent which appropriately limits the power of the feds to lay taxes.

"Congress is not empowered to tax for those purposes which are within the exclusive province of the States." --Chief Justice Marshall, GIBBONS V. OGDEN (1824) supreme.justia.com/us/...

So Obama's stimulus package, based on constitutionally non-existent powers, can be thought of as the feds returning to the states money that it had stolen from the states anyway.

Finally, since R Jensen mentioned the 16th Amendment, the amendment that gives the feds the power to tax citizens directly, please consider the following. Citizens need to work with their state lawmakers to repeal the 16th A. This is because that amendment has made it too easy for the federal government to lay constitutionally unauthorized taxes, in my opinion. Citizens and state lawmakers need to repeal the 16th A. and decide on another way to finance the federal government, keeping the feds on their constitutional leash.

Mar 25 06:30 PM

[khl:]

Everyone agrees that the fed caused the depression. Friedman, et al believe it was because they didn't provide enough credit during the 1930's and also that they allowed the Bank of the United States to collapse, at least partly due to anti-semitism, thus creating a bank run which caused a 30 percent decrease in the money supply and led to massive deflation. I remember my granfather telling me stories about how supermarkets couldn't change one hundred dollar bills and that you could buy them for around ninety dollars. The Austrians believed that the depression was caused by inflation that occurred during the 1920's which went into the stock market, leading to over leveraging and eventual bust. Either way, they all agree that the Fed caused it.

Prior to the Fed, a bank had to be prepared for the possibility of a bank run. The Fed through its cash-management function was supposed to provide enough cash to its member banks to stop runs from occurring. Hah. Of course we all know that if every depositor wanted their money back at once, no bank could survive. It only happened when people believed their money was at risk. Therefore, the bank had an incentive to lend responsibly and to their lenders' businesses. In addition, they generally kept 20 percent reserves on hand. This is why old bank buildings were so imposing. So clients would be reassured of their financial strength. They wouldn't go pissing their money away on CDS's CDO's or other gambles.

Mar 25 06:32 PM

[nukldrager:]

The origins may go further back to an understanding of finance as described by this quote;
"The man who controls Britain's money supply controls the British Empire, and I control the British money supply."
(Nathan de Rothschild)

The unconstitutional Federal Reserve Act of 1913 continues that theme, now on a global scale.

Mar 26 07:02 AM

[john s. gordon:]

r jens -

IRS became necessary because prior to 1913 u.s govt was funded by import duties. the collector of each major port city was a very influential person.
the 1898 (spain) war was funded by issuance of revenue stamps for every conceivable commodity.
by 1913 these sources of revenue had become inadequate.
> jack

Mar 28 09:28 AM