The standard explanation of the Depression I learned in school was that the crash caused a crisis of confidence which turned into a reinforcing cycle: people stopped spending, which caused businesses to lose money and lay people off, causing people to stop spending, etc. The problem with this explanation is that it fails to explain what made the depression different: such cyclical crashes happen all the time, and while other crashes were bad, none of them were even remotely comparable to what happened in the depression.
As far as I can figure out, the standard modern conservative explanation of the depression is that a normal business cycle downturn was exacerbated by misguided attempts by the Hoover and Roosevelt administration to fix the problem, and that if instead they had just followed Mellon's advice to do nothing, purge the excesses from the system, and wait for a normal recovery, things wouldn't have been nearly as bad. That story does a better job of explaining why the depression was different, but it fails to explain why similar attempts to manage downturns in the postwar period didn't fail, and it fails to account for the fact that the economy began picking up after the end of the bank holiday in 1933 (eg, that the worst of the contraction came before the attempts to fix the situation, and that the attempts to fix the situation were time-correlated with economic improvement).
Lords of Finance presents a more complex picture of the period, focusing on the behavior of the central bankers, and concludes that the depression was actually the result of multiple more or less simultaneous crises: imagine the 1994 peso crisis, the 1997-98 asian and russian crises, the 2000 stock market collapse, and the 2008 credit crisis, all collapsed into two years. And all of them, the book alleges, traceable to mistakes made by the central bankers of the 1920s in trying to deal with the after-effects of the Great War.
Some interesting data points thrown out to try to create an impression of the picture painted by the book:
- because of the way that the european governments were financing the war, and becausse of a legitimate fear that property would be confiscated or destroyed during the war, and because of the way the Soviets handled the tsarist collapse, something like 65% of the world's gold reserves were in the US at the end of the war. This created a serious imbalance in the international payment scheme: the European powers didn't have enough gold to back their currencies, and the US had too much gold. In the US, this led to efforts by the Fed to manipulate the economy for the purpose of preventing runaway inflation, as runaway inflation might be expected when an economy whose currency is backed by gold suddenly experiences a large influx of gold. Meanwhile, the lack of local gold reserves made it more difficult for the European powers to go back to a gold standard after the war.
- every government had financed the war via inflation, some more than others. The result of this was that, in order to get the currencies back on a gold standard at the same price as before the war, every country had to run deflationary policies designed to force prices back down to pre-war levels. These deflationary policies meant credit contraction, which caused industrial contraction and widespread unemployment in the early 1920s. (The US was immune to this particular problem because of the gold influx).
- The socialist German government, faced with spiraling unemployment and decades of pent up demands from labor, went on a spending binge. The old-school head of the Reichsbank, Rudolf von Havenstein, who had opposed the use of inflation to fund the war, printed the money the social democratic government needed to pay for its policies because he was afraid that, if he didn't, they would just borrow it - and the borrowing would drive up interest rates (by increasing demand for money), triggering even worse credit contraction and, he feared, a communist revolution. (Which is to say: the head of the Reichsbank caused the hyperinflation because he was afraid that if he didn't, the cotnractionary policy would trigger a communist revolution).
- The post-hyerpinflation German economic boom was entirely dependant on short-term borrowing from US financial institutions. When the US stock market bubble began in 1927, all of the money which had been placed in short-term loans to german companies and local governments was repatriated, causing a severe economic contraction in Germany.
- When England went back on the gold standard, it did so before prices had returned to pre-war levels. As a result, the pound was seriously overvalued the entire time England remained on the gold standard, and the result was that interest rates had to be kept high (to avoid a further flight of gold), causing slow economic growth, a decline in the manufacturing and industrial sector, and widespread unemployment. Winston Churchill, who oversaw the return ot the gold standard, later blamed it on Norman, and maintained it wass the worst mistake he'd ever made.
- When France went back on the gold standard, it did not maintain the same price of gold as before the war, and picked a redemption value which left its currency seriously undervalued. This led to a massive economic boom in France, but it also led to a funneling of gold from Germany and England into France, further exacerbating the worldwide gold imbalance.
- England had convinced the other central banks to consider the pound to be equivalent to gold, and to allow their currencies to be backed by pounds. The result of this was that, by the late 1920s, the French central bank held a huge quantity of pounds, and was in a position to threaten the English central bank with absolute destruction: if it actually tried to redeem its pounds for gold, the central bank's gold reserves would be wiped out.
- The US stock market bubble was triggered by the NY Fed's decision to lower interest rates for the purpose of encouraging gold to move from the US to England in the hopes of relieving the pressure on the pound. By the time the fed realized its mistake, it was too late to control the bubble.
- The crash of 1929, while bad, was not the disaster that the depression became; there was a contraction - it had already started some months before the crash - but it generally avoided becoming a true panic, except in Germany, where the economy had already collapsed as a result of the withdrawal of credit due to the US boom.However, it acted to eexacerbate some of the problems already implicit int he world economy: gold fled into the US from Germany and England, forcing deflation on both.
- The German election of September 1930 triggered a market panic in which half of the Reichsbank's gold reserves wre withdrawn. To remain solvent, the Reichsbank hiked its rates to 5 percent, which when combined with 7 percent deflation, meant an effective cost of money of twelve percent, which just exacerbated the unemployment problem. Germany, terrified by the memory of the hyperinflation, responded with an austerity budget which cut all state officials salaries, and raised taxes. This intensified the deflation.
- Things really began to go wrong when Credit Anstalt, the Austrian branch of the Rothschild empire, failed. It had lost $20 million in 1930, and was as a result technically insolvent. (At least part of this was because it had been persuaded by the Austrian National Bank to take over its largest rival when that rival was about to go under). Austria tried to step in with a rescue package, but the package was insufficient to stem the panic, and every bank in Austria was taken down before the major central bankers managed to put together a rescue package. The Austrian currency was next. Attempts to forge a multinational bail out of the Austrian national bank foundered when France demanded that Austria abolisih a proposed customs union with Germany; Norman (of the Bank fo England) got pissed off and committed the Bank of England to providing the bailout loan itself. This simply transferred the panic to England, which was overcommitted because of its overpriced currency.
- The panic in Austria caused a gold flight from Germany, which lost more than 50% of its remaining gold reserves before the US proposed a bailout package: the US would forgo one year's worth of war debts in exchange for the debtors forgiving one year of German reparations. Hoover lined up American political support but failed to talk to the French government in advance of the announcement; the prickly French refused to play for almost two months, by which time the third largest bank in Germany ran out of reserves and became insolvent. The Reichsbank couldn't bail it out; it didn't have enough gold left.
- The immediate result of the Danatbank's failure was a bank panic throughout central Europe. To quell the panic, Germany had a two week bank holiday, during which all economic holiday halted, and banks in the rest of central EUrope closed for a similar period. (Within the next six months, the economy contracted another 20%, representing a ttoal 60% contraction since the start of the American boom)
- After the German and Austrian disasters, people started demanding that their pounds be exchanged for gold, and the Bank of England lost half of its gold reserves in the first half of July, 1931. So it responded by almost doubling interest rates, and trying to borrow money from the US to support the pound. The Fed wasn't able to produce the money, so the House of Morgan promised a support loan in exchange for the government adopting an austerity package. The government fell, the new government adopted the requested package, and the entire loan amount was gone (in gold redemption of pounds) by mid-September. This forced the UK off the gold standard. At that point, the need to protect the gold reserve gone, it was free to lower interest rates, and the economy began to recover.
- THe panic then spread to the US; the european central banks which held dollars demanded dollar conversion into gold, causing a $750 million (in comparable numbers, $150 billion) withdrawal of gold from the US economy over the course of five weeks. This wasn't a huge deal, as the fed had a $4.7 billion gold reserve, but because the currency was required by law to be backed by a 40% gold reserve and the remaining 60% could only come from specified kinds of paper instruments, and because those specified kinds of paper instrument had become rare as a reuslt of the decrease in trade, the Fed was forced to significantly contract the money supply as a result of the gold withdrawals, and it was forced to raise interest rates substantially to prevent loss of its gold reserves.
- Banks started going under in large number in the US in the summer of 1930. This was a distinct phenomenon from the major European bank failures - it was a normalish banking panic which started with the collapse of a real estate bubble in Chicago and spread outward from there when depositors, spooked by the general situation, started pulling their deposits from all banks and hoarding the money, forcing the banks to build up their cash reserves and call in loans, forcing people to withdraw money to pay off the loans, a true vicious cycle - but the timing, coincident with the gold withdrawal triggered by the European failures, was terrible: each caused their own seperate contraction in the money supply, and the two of them together was truly phenomonal.
- Between September 1931 and June 1932, the total amount of bank credit in the US fell by 20%. But this was still largely confined to particular regions: what we now call the rust belt (after the Chicago bubble), Florida (after a land bubble there burst), New York (because of the EUropean crisis).
- In early 1933, the Guardian Trust Company of Detroit, a bank run by Edsel Ford, failed. Henry Ford refused to bail it out. The panic became a run on the banking system throughout the state of Michigan; the governor shut down the banks for eight days (on February 14). This caused a truly national panic; by the inauguration (March 4), 28 states had completely closed their banks and 20 other states had partial closures
- This also provoked a run on the dollar, worse than the one which had happened in 1930-1931.
- On March 2, two days before inauguration day, the NY Fed fell below its legally required gold reserve ratio. The next day, it fell $250 million below the required ratio, and when it tried to borrow from the Chicago Fed, the Chicago Fed refused.
- Hoover desperately tried to stem the panic by getting Roosevelt to agree to a joint statement and a joint proclamation of a bank holiday. Roosevelt refused. Hoover was unwilling to act on his own. (One of Roosevelt's first actions was to declare a bank holiday, but the delay of days under those circumstances inflicted a horrible cost.
- Every one of Roosevelt's financial advisors was opposed to his decision to take the US off the gold standard.
It's particularly disturbing to be reading this history right now, and it's very hard not to see in it parallels to the modern era. The Euro, in particular, seems like a disaster waiting to happen, the modern equivalent to the gold standard. True, there's no redemption possible, which means that there can't be a currency crisis triggered by an attempt to convert euros into drachmas. But the fundamental economic problem caused by interest rates which are set, not by the needs of the domestic economy, but by the needs of the international money market, remains. Greece, Italy, Spain, and Portugal really need to inflate, but they can't; at least not until they're forced out of the euro - and once that happens, the panic will spread to other countries.
- The US <> China dynamic today bears a disturbing resemblence to the Britain <> France dynamic in the late 1920s; just as France's central bank held a huge quantity of pounds which it could hold over England's head, China holds a huge quantity of dollars which it can hold over ours. True, we can't be forced to redeem them for gold (thereby shrinking our money supply), but they can be dumped on the market. Similarly, our currency is probably overvalued, and everyone agrees China's is undervalued; that difference is exacerbating the trade deficit between the two countries and, by encouraging an outflow of dollars from the US to China, increasing the instability of the system.
- Going back on the gold standard was, for most countries, a mistake in the 1920s; and the austerity packages adpted to keep the countries on the gold standard generally made things worse, rather than better. We should take note.
- And, the big takeaway: holy hi, we dodged a bullet in 2008. Far from being the traitors that certain Republicans would have them be, Bernanke and Paulson were heros; the credit crunch of 2008 could easily have been a disaster which would have made the current bad economic times look like a party by comparison. (And, honestly, as much as I don't like him, I have to give credit to President Bush here, too; Paulson couldn't have acted without at least Bush's acquiescence).
- And, the scary part: it might not have been enough. THe tale of the 1920s is a tale of lurching from one crisis to another until the fundamental mistakes, made at the beginning of the era, forced an unravelling. The last several years have been a tale of lurching from one crisis to another, and there's no sign that anyone is even trying, in any serious way, to look at the causes of contemporary economic unbalance (overvalued dollar / undervalued yuan; decline of US manufacturing base and consequent inability to sell things which would allow the repatriation of dollars; european economies trapped in stagnation by the euro and by german-inspired austerity demands).
And, look: a major commodities trading firm (run by Jon Corzine) just went down. And: Greece is almost certain to reject the EU bailout package. Odds on them being forced out of the euro look good.
And: Where is this generation's Keynes, to tell us where it all went wrong?
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