Posted on 04/20/2003 5:21:01 PM PDT by sourcery
Does a Falling Money Stock Cause Economic Depression?
By Frank Shostak
[Posted April1 18, 2003]
Despite the aggressive lowering of the federal funds rate target from 6.5% in December, 2000 to the current level of 1.25%, U.S. economic activity remains subdued. Faced with a lackluster response to this aggressive monetary stance, it is tempting to draw parallels with the 1930's economic depression.
Most economists hold that such comparisons are not warranted. Following the writings of Milton Friedman, they are of the view that the policy makers of the Fed have learned the lesson of the Great Depression and know how to avoid a major economic slump.
In his writings Milton Friedman blamed central bank policies for causing the Great Depression. According to Friedman the Federal Reserve failed to pump enough reserves into the banking system to prevent a collapse in the money stock (Milton and Rose Friedman's Free To Choose). In response to this failure, Friedman argues, money stock, M1, fell by 33% between late 1930 and early 1933 (see chart).
According to Friedman, as a result of the collapse in the money stock economic activity followed suit. Thus by July 1932 year-on-year industrial production fell by over 31% (see chart). Also, year-on-year the consumer price index (CPI) had plunged. By October 1932 the CPI fell by 10.7% (see chart).
However, a close examination of the historical data shows that contrary to Friedman the Fed was extremely loose and pumped reserves into the system in its attempt to revive the economy (on this see Murray Rothbard's America's Great Depression). The extent of monetary injections is depicted by changes in the Fed's holdings of U.S. government securities. Thus on January 1930 these holdings stood at $485 million. By December 1933 they had jumped to $2,432 million—an increase of 401% (see chart). Moreover, the average yearly rate of monetary injections by the Fed during this period stood at 98%.
Also, short-term interest rates fell from almost 4% at the beginning of 1930 to 0.9% by September 1931 (see chart). Another indication of a loose monetary stance on the part of the Fed was the widening in the differential between the yield on the 10-year T-Bond and the yield on the 90-day Bankers Acceptances. The differential rose from -0.51% in January 1930 to 2.37% by September 1931 (see chart).
The sharp fall in the money stock between 1930 to 1933, contrary to Friedman, is not indicative of the Federal Reserve's failure to pump money. Instead it is indicative of a shrinking base of investable capital brought about by the previous loose monetary policies of the central bank. Thus the yield spread increased from -0.9% in early 1920 to 1.9% by the end of 1925 (an upward sloping yield curve indicates loose monetary stance). The reversal of the stance by the Fed from 1926 to 1929 burst the monetary bubble (see chart).
In addition to this, at some stages monetary injections were massive. For instance, the yearly rate of growth of government securities holdings by the Fed jumped from 19.7% in April 1924 to 608% by November 1924. Then from 0.3% in July 1927 the yearly rate of growth accelerated to 92% by November 1927. Needless to say that such massive monetary pumping amounted to a massive exchange of nothing for something and to a severe depletion of the pool of real funding, that is, the essential source of current and future capital needed to sustain growth.
As long as the pool of real funding is expanding and banks are eager to expand credit (credit out of "thin air") various nonproductive activities continue to prosper. Whenever the extensive creation of credit out of "thin air" lifts the pace of real-wealth consumption above the pace of real-wealth production the flow of real savings is arrested and a decline in the pool of real funding is set in motion. Consequently, the performance of various activities starts to deteriorate and banks' bad loans start to rise. In response to this, banks curtail their lending activities and this in turn sets in motion a decline in the money stock.
The fall in the money stock begins to further undermine various nonproductive activities, i.e. an economic depression emerges. In this regard after growing by 2.7% year-on-year in January 1930 bank loans had fallen by a massive 29% by March 1933 (see chart).
How is it possible that lenders can generate credit out "of thin air" which in turn can lead to the disappearance of money? Now, when loaned money is fully backed up by savings, on the day of the loan's maturity it is returned to the original lender. Thus, Bob—the borrower of $100—will pay back on the maturity date the borrowed sum plus interest. The bank in turn will pass to Joe, the lender, his $100 plus interest adjusted for bank fees. To put it briefly, the money makes a full circle and goes back to the original lender.
In contrast, when credit is created out of "thin air" and returned on the maturity day to the bank this amounts to a withdrawal of money from the economy, i.e, to a decline in the money stock. The reason for this is because there wasn't any original saver/lender, since this credit was created out of "thin air."
It follows then that the sole cause behind the wide swings in the stock of money is the existence of fractional reserve banking, which gives rise to unbacked-by-savings credit. (In the Mystery of Banking Murray Rothbard showed that it is the existence of the central bank that enables fractional reserve banking to thrive).
Observe that economic depressions are not caused by the collapse in the money stock (as suggested by Milton Friedman), but come in response to a shrinking pool of real funding on account of previous of loose money. Consequently, even if the central bank were to be successful in preventing the fall of the money stock, this would not be able to prevent a depression if the pool of real funding is declining. Also, even if loose monetary polices were to succeed in lifting prices and inflationary expectations (as suggested by Paul Krugman), this would not revive the economy as long as real funding is declining.
Again, note that contrary to popular thinking, depressions are not caused by tight monetary policies, but are rather the result of previous loose monetary policies. On the contrary, a tighter monetary stance arrests the depletion of the pool of real funding and thereby lays the foundations for economic recovery. Furthermore, the tighter stance reveals the damage that was done to the capital structure by previous monetary policies.
Have we learned the lesson of the Great Depression?
Do central banks have all the necessary tools to prevent a severe economic slump similar to the one that occurred in the 1930's? Most economists are adamant that modern central banks know how to counter the menace of a severe recession.
But if this is the case why has the central bank of Japan failed so far in reviving the Japanese economy? The Bank of Japan (BOJ) has used all the known tricks as far as monetary pumping is concerned. Thus interest rates were lowered to almost zero (see chart) while BOJ monetary pumping as depicted by its holdings of government securities increased by 323% between January 1990 and March 2003 (see chart).
It is likewise in the U.S. For over two years the Fed has been aggressively lowering interest rates and yet economic activity remains subdued (see chart). For instance, in relation to its long-term trend industrial production remains in free fall (see chart). The Fed's holdings of government securities have increased by 189% between 1990 Q1 and 2002 Q4. The yearly rate of growth of these holdings jumped to 14.1% in Q4 2002 from 9.8% in Q1 (see chart).
Moreover, a steep fall in the personal income to personal outlays ratio indicates that the pool of real funding is under pressure (see chart). Note that during the 1930's the fall in this ratio wasn't as steep as now (see chart).
We suspect that there is a strong likelihood that if the economy does not rebound soon, the Fed will lower interest rates further and will intensify its monetary pumping. This, however, will only further prolong the economic misery.
Sure, b/c Target, K-Mart, HomeDepot, Sears, Penney's, et. al. would continue to stock Chinese/foreign(made) goods and in the process nail Wal-Mart to the wall, e.g. Wal-Mart would offer a 13 gallon white plastic trash can MADE IN USA for $5.45, while down the street Target would offer the same 13 gallon white trash can, made in Mexico, for $3.99.
The significant thrust of the article is to respond to the monetarist economist conventional wisdom that the events of 1929 were caused by a failure of sufficient liquidity. That is a simple factual data issue. The conventional wisdom is simply wrong--not supported by the data. Facts are that the fed pumped money to the maximum extent possible and money supply went down because no one borrowed the money.
My point is that not only is the Conventional Wisdom which dictates the lower interest rate cheaper reserve banking answer wrong, but that the real cause of deflations and depressions can be seen in Fed policy errors that resulted in increased debt and debt service.
Your point about the difference in collateral today versus 1929 is correct--in 29, the collateral was margined stock equity and today, the principal collateral is real estate.
And it clearly makes some difference. But we differ a little in what those differences are. Common stocks are the subject of a daily quotation report--values are the trading prices on the margin--so everyone knows exactly what today's trading price is. In real estate, it is not quite so clear. I would argue that in fact, real estate is tanking but the price ranges and geographical locations in which price declines are occuring are diverse. I further differ with you on the future although that is just an opinion--I think we will ultimately see the cascading decline in values in residential real estate when owners recognize that values have slipped away from them.
Your argument that won't happen is based on two prositions: One, there is residual equity that will permit the owner to continue to hold through the slide; and two, mortgagees won't foreclose because they would rather get something out of the debt and have the property in REO.
I think existing equities are very very thin, in large part because of the refi boom. And historically lenders have taken the property back because of their experience that when they don't, maintenance stops and the value of the collateral deteriorates.
In most markets, we are working our way through the time period where the seller can wait to market the property at a high price--we are seeing deferred monthly payments; interest only; and deals where financing on the new house is structured to carry the debt service on the old house during a marketing period. That time is coming to an end.
I also think the current stock market values indirectly support real estate values. Owners continue to view their stock mutual fund portfolios as having some retained value--so they continue to hold the real estate for sale at above market prices. When the stock market declines, real estate values will follow.
"How does debt result in deflation? Having read these words several times I find myself still puzzled by the wording/meaning of this question. Is the question: 'How does deflation effect debt?'"
No. My analaysis is that excess levels of debt are the primary cause of deflations like the one which occurred in 1929 as a result of the margin debt creation of which was facilitated by the fed in the mid 20's; and like the current situation which is the result of excess debt at every level, credit card consumer; mortgage; government and business, facilitated by fed policy in the early and mid 90's.
The excess debt requires commitment of current liquidity wherever it comes from, to payment for past spending and acquisitions rather than current utility. Entities (individual and otherwise) are using current cash flow to pay for spending that occured some time ago. Thus current spending is curtailed.
Deflation results because entities can no longer cause increases in money supply because they don't have excess liquidity to make monthly payments on new debt because all excess liquidity is commited to old spending. Deflation further results from retirement of existing debt--the amount of debt retirement comes out of the money supply. So money supply sinks and you get deflation which ultimately progresses into depression in the extreme version.
The 1990's experience is more serious than the 1920's version because the amount of debt is much greater and the excess exists in more segments of the economy.
Your description of the assumptions that lead entities to incur debt and lenders to make the loan is correct. And the default in that assumption is what has caused the problem. If incomes, profits, tax revenues and values continued up, there would be increasing liquidity to make payments on existing debt plus pay for additional purchases. Problem is that incomes, profits, tax revenues and values are now going down--the Fed made a serious policy error and facilitated the creation of so much excess debt in the 90's that current liquidity is curtailed to a degree that has resulted in layoffs, lower compensation, loss of pricing power and the like resulting in a major deflationary period which is now becomeing a depression.
I am not sure what you mean by your concluding point. In order to get out of this without a major adjustment shock--2 out of every 3 houses in foreclosure; Dow at 1200; municipal bond defaults; you need to be able to see how incomes and revenues go up and available liquidity is generated other than through borrowings. Since I don't see that happening, I think the political answer ought to be to look for a way to resolve the illiquidity problem.
We could amend the Bankruptcy Act to permit debtors to elect to hand over all their net collateral assets in a speeded liquidity proceeding to the creditors. We need a legal mechanism to get through the procees that took us from 1930 to 1949 the last time. We need a sound money system so that creditors and debtors alike can be sure that when their liquidity problems are resolved, they can go back to work free from concern that government policy will rob them of the proceeds of their endeavors.
With all due respect, I think that is probably not correct.
It is a fact that the money supply contracted after the stock market crash of 1929. But it is also a fact that the money supply is probably contracting (when we agree on what the measure of the real money supply is) today, when the Fed is running the printing press as fast as it can with no letup in sight.
It works that way because in order for printing press money (additional bank reserves or cheaper bank reserves) to get into the money supply, the reserves must be the base for additional net lending. Didn't happen in the 1930's; not happening today either.
Reason why, today, is because borrowers and potential borrowers don't have available additional excess liqudity to make payments on additional net borrowings. A little different from 1929 because in 1929, the cycle came to an end because stock values collapsed and could no longer serve as a base for additional borrowing. The measurable deflation results in part because of debt retirements as it did in the 1930's. Although much debt retirement in the 1930's resulted from foreclosures which are just getting started today.
Point is that the only way that can be reversed is if incomes go up; if tax revenues go up; if business profits go, creating additional liquidity flow to pay for new net marginal acquisitions. I don't see any way that can happen.
"Protectionism"? Well I was taught, like you, that Smoot- Hawley (the tarriff act) was one of the primary causes of the depression. I no longer think that is true either.
No doubt that in an expanding economy, free trade benefits the largest part of a domestic economy--the only losers are domestic suppliers at prices higher than the free trade world price.
But in a deflation/depression, a little protectionism probably does not make very much difference one way or another. The "Smoot-Hawley caused the depression" argument is another afterthought that was devised to defend the fed against responsbility for the great depression. Real bottom line is that deflation is a monetary phenomonon resulting from defective Fed policy. We don't have protectionism now and deflation is becoming embeded and will become a Greater Depression in the near future.
We don't have protectionism today and we have the problem; I don't think Smoot-Hawley had much to do with the depression we got in the 30's either.
Under Reaganomics we went to a supply side economy for many things. That type of tax incentive eventually resulted in an "Honest Dollar" and more revenue with an expanded economy. We need Bushonomics and an end to tax on interest income and dividends paid to individuals etc.
It was Greenspan who admitted in 2003 he failed to slow the econmy in 1997 and caused the stock market bubble to Burst. It was Greenspan who failed to cut interest rates when Poppa Bush ran for election and the economy had faltered. It was Greemspan who stated in Jan. that we do not need a tax cut, just as he couldn't spur the economy with any more significant interest cuts. We need a Milton Friedman; we need someone whose ideals aren't politcal disguised as neutral. Greenspan goes for a prostrate operation tomorrow. I wish him well but can't help thinking...one slip and we will have a robust economy. We are just a "hair away".
That point is not addressed to commentary about appropriate levels of taxation and spending but to the pure monetary measuring stick issue--at the moment, governments at every level do not have enough tax revenue to pay existing commitments.
That is the result of the deflationary economic contraction in the general economy.
The country is still generally in denial--"the stock market bottom is in"; "real estate has real value and can't go down"; "recovery in the second half"; denial that the real problem is an imbeded deflation resulting from excess levels of debt.
So my point is, ok, what does it take to make the denial analysis work--what makes the stock market go up; keep the real estate bubble from collapsing; and see a general economic recovery? What would you expect to see if the denial argument was going to be correct?
And one of the things you would see very early is increasing tax revenues at the state, local, and federal income tax levels. Fact we are not seeing those revenues is the most important indicator that those in denial will not be correct.
This question is of course one we revisit regularly--in other versions, summarized, as--can the fed stop deflation by printing money to cause inflation instead of deflation (devaluing the dollar instead of seeing it increase in value as it would in a deflation).
The fed can do only a couple of things to influence the money supply. It can make bank reserves cheaper (the fed funds--interbank borrowing rate; or the new discount rate policy); it can buy government debt in the open market.
In fact, week before last, the fed bought some government debt and the bond market went down and interest rates went up (the opposite of what would be expected). I tend to doubt the buy government debt policy because it is so clear that will probably be counterproductive--everyone now watches open market activity.
So if the question is restricted to, can the fed, by fed monetary policy alone (facilitating more and cheaper bank lending through the reserve mechanism) cause deflation to become inflation, I think the answer is "No".
But there is still room for some uncertainty in the ultimate outcome.
Shostak's article is data in support of the proposition that the fed can't make the money supply go up and could not do so in the 30's.
However there is another money creation issue. The US Government runs deficits and borrows the money. Although those deficits seem huge, facts are in the context of the overall money supply and available investment liquidity, the deficits are tiny and such a minor interest rate adjustment they are not readily apparent in the short term.
But you could foresee that the deficits got to a point where they can't be financed in the normal money market activity and the fed had to print money to buy federal bonds. You would then foresee the outcome they got last week alright--interest rates up; dollar now selling off; gold going up. And presumably a lot of additional liquidity into the money supply. Result would be inflation not deflation.
It just isn't clear what the end result would be of Government Fiscal policy directed toward federal overspending for the purpose of causing the fed to act in the monetary markets in such a way as to cause inflation. It might happen that way. One of the principal reasons gold is going up is because of the risk (not the existing fact--as in "it will happen that way") that might be the outcome.
Oh the irony! the answer is there in front of your nose, and you dont see it. You only need credit if you have demand that can support your paying back debt. For businesses that demand comes from demand for products... the end-user demand creates the profit margins, which enables further credit expansion.
The reason Smoot-Hawley was so deadly was that it killed end-user demand on the margin. That killed demand for credit, and lower demand fed on itself ... To Keynes, this made it look like the whole economy was 'under potential', but that was because the economy was built for a level of export demand that no longer existed, thanks to world-wide trade barriers getting raised. Lower demand fed on itself.
You say: "I don't see any way that can happen." There are a few simple ways to reflate *credit demand*, not just money supply. New technologies/products; new markets; better margins. Govt-wise, the levers are tax cuts and their twin - trade barrier reductions.
The last honest words that Greenspan uttered were when he talked about "irrational exuberence". Immediately following, something fundamentally changed with Greenspan and at the FED. It was a total sell-out to the political powers. The question is what kind of pressure/blackmail/promises were brought to instigate the change. Did Bubba send a message to Greenspan that he would be destroyed in the media or was it the carrot of being called Maestro and Sir Alan? We'll never know.
With the political corruption of Greenspan and the FED, rational economic thinking and policy has been turned on its head. The objective of the FED is now to keep the Washington elite ruling class in power regardless of particular party. Economic downturns and recessions aren't good for popularity and approval ratings, so the FED pushes ahead with a debasement of the currency, wild expansion of debt, and inflate or die policy even as it knows that the consequence will someday be catistrophic for the average citizen and the economy in general. IMHO
Richard W.
| The excess debt requires commitment of current liquidity wherever it comes from, to payment for past spending and acquisitions rather than current utility. Entities (individual and otherwise) are using current cash flow to pay for spending that occured some time ago. Thus current spending is curtailed... Deflation results because entities can no longer cause increases in money supply because they don't have excess liquidity to make monthly payments on new debt because all excess liquidity is commited to old spending. Deflation further results from retirement of existing debt--the amount of debt retirement comes out of the money supply. So money supply sinks and you get deflation which ultimately progresses into depression in the extreme version.
I encourage you to lose that second part. I think it weakens your case. It's trying to have it both ways: the guy can't buy anything new because all his money is going to service his debt, but just wait until he retires the debt because then things will get even worse. It's "damned if we do and damned if we don't," even though history shows that most of the time we're not damned at all. I understand what Ludwig & Co. are trying to say, but I have never bought their premise. The idea that money originally created by fiat, and lent out, "expires" when the debt is retired has the hidden assumption behind it that the money created no new wealth while it was out there. That's the "economic growth=zero" assumption that underlies an embarassing amount of von Mises' stuff. In 28, yankeedame caught another place where they do it. Their scheme is quite rigorous and logically consistent, but as soon as you introduce a value other than zero for economic growth, a lot of it falls apart like a cheap suit. |
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The first part of that makes sense and is a reasonable explanation for how excessive levels of debt could bring about deflation. I don't know that it explains the current condition because I don't happen to have data on the percentage of disposable income that Joe Average is pouring into debt service these days, but in theory it could happen and recent data may well support the idea that it is happening right now.