Courtesy of David Stockman @ Contra Corner Blog:
One hundred years ago today the world was shook loose of its moorings. Every school boy knows that the assassination of the archduke of Austria at Sarajevo was the trigger that incited the bloody, destructive conflagration of the world’s nations known as the Great War. But this senseless eruption of unprecedented industrial state violence did not end with the armistice four years later.
In fact, 1914 is the fulcrum of modern history. It is the year the Fed opened-up for business just as the carnage in northern France closed-down the prior magnificent half-century era of liberal internationalism and honest gold-backed money. So it was the Great War’s terrible aftermath—–a century of drift toward statism, militarism and fiat money—-that was actually triggered by the events at Sarajevo.
Unfortunately, modern historiography wants to keep the Great War sequestered in a four-year span of archival curiosities about battles, mustard gas and monuments to the fallen. But the opposite historiography is more nearly the truth. The assassins at Sarajevo triggered the very warp and woof of the hundred years which followed.
The Great War was self-evidently an epochal calamity, especially for the 20 million combatants and civilians who perished for no reason that is discernible in any fair reading of history, or even unfair one. Yet the far greater calamity is that Europe’s senseless fratricide of 1914-1918 gave birth to all the great evils of the 20th century— the Great Depression, totalitarian genocides, Keynesian economics, permanent warfare states, rampaging central banks and the exceptionalist-rooted follies of America’s global imperialism.
Indeed, in Old Testament fashion, one begat the next and the next and still the next. This chain of calamity originated in the Great War’s destruction of sound money, that is, in the post-war demise of the pound sterling which previously had not experienced a peacetime change in its gold content for nearly two hundred years.
Not unreasonably, the world’s financial system had become anchored on the London money markets where the other currencies traded at fixed exchange rates to the rock steady pound sterling—which, in turn, meant that prices and wages throughout Europe were expressed in common money and tended toward transparency and equilibrium.
This liberal international economic order—that is, honest money, relatively free trade, rising international capital flows and rapidly growing global economic integration—-resulted in a 40-year span between 1870 and 1914 of rising living standards, stable prices, massive capital investment and prolific technological progress that was never equaled—either before or since.
During intervals of war, of course, 19th century governments had usually suspended gold convertibility and open trade in the heat of combat. But when the cannons fell silent, they had also endured the trauma of post-war depression until wartime debts had been liquidated and inflationary currency expedients had been wrung out of the circulation. This was called “resumption” and restoring convertibility at the peacetime parities was the great challenge of post-war normalizations.
The Great War, however, involved a scale of total industrial mobilization and financial mayhem that was unlike any that had gone before. In the case of Great Britain, for example, its national debt increased 14-fold, its price level doubled, its capital stock was depleted, most off-shore investments were liquidated and universal wartime conscription left it with a massive overhang of human and financial liabilities.
Yet England was the least devastated. In France, the price level inflated by 300 percent, its extensive Russian investments were confiscated by the Bolsheviks and its debts in New York and London catapulted to more than 100 percent of GDP.
Among the defeated powers, currencies emerged nearly worthless with the German mark at five cents on the pre-war dollar, while wartime debts—especially after the Carthaginian peace of Versailles—–soared to crushing, unrepayable heights.
In short, the bow-wave of debt, currency inflation and financial disorder from the Great War was so immense and unprecedented that the classical project of post-war liquidation and “resumption” of convertibility was destined to fail. In fact, the 1920s were a grinding, sometimes inspired but eventually failed struggle to resume the international gold standard, fixed parities, open world trade and unrestricted international capital flows.
Only in the final demise of these efforts after 1929 did the Great Depression, which had been lurking all along in the post-war shadows, come bounding onto the stage of history.
America’s Needless Intervention In The Great War And The Ensuing Chain of 20th Century Calamities
The Great Depression’s tardy, thoroughly misunderstood and deeply traumatic arrival happened compliments of the United States. In the first place, America’s wholly unwarranted intervention in April 1917 prolonged the slaughter, doubled the financial due bill and generated a cockamamie peace, giving rise to totalitarianism among the defeated powers and Keynesianism among the victors. Choose your poison.
Even conventional historians like Niall Ferguson admit as much. Had Woodrow Wilson not misled America on a messianic crusade, the Great War would have ended in mutual exhaustion in 1917 and both sides would have gone home battered and bankrupt but no danger to the rest of mankind. Indeed, absent Wilson’s crusade there would have been no allied victory, no punitive peace, and no war reparations; nor would there have been a Leninist coup in Petrograd or Stalin’s barbaric regime.
Likewise, Churchill’s starvation blockade would not have devastated post-Armistice Germany, nor would there have been the humiliating signing of the war guilt clause by German officials at Versailles. And the subsequent financial chaos of 1919-1923 would not have happened either—-meaning no “stab in the back” myth, no Hitler, no Nazi dystopia, no Munich, no Sudetenland and Danzig corridor crises, no British war to save Poland, no final solution and holocaust, no global war against Germany and Japan and no incineration of 200,000 civilians at Hiroshima and Nagasaki.
Nor would there have followed a Cold War with the Soviets or CIA sponsored coups and assassinations in Iran, Guatemala, Indonesia, Brazil, Chile and the Congo, to name a few. Surely there would have been no CIA plot to assassinate Castro, or Russian missiles in Cuba or a crisis that took the world to the brink of annihilation. There would have been no Dulles brothers, no domino theory and no Vietnam slaughter, either.
Nor would we have launched Charlie Wilson’s War to arouse the mujahedeen and train the future al Qaeda. Likewise, there would have been no shah and his Savak terror, no Khomeini-led Islamic counter-revolution, no US aid to enable Saddam’s gas attacks on Iranian boy soldiers in the 1980s.
Nor would there have been an American invasion of Arabia in 1991 to stop our erstwhile ally Hussein from looting the equally contemptible Emir of Kuwait’s ill-gotten oil plunder—or, alas, the horrific 9/11 blowback a decade later.
Most surely, the axis-of-evil—-that is, the Washington-based Cheney-Rumsfeld-neocon axis—- would not have arisen, nor would it have foisted a $1 trillion Warfare State budget on 21st century America.
The 1914-1929 Boom Was An Artifact of War And Central Banking
A second crucial point is that the Great War enabled the already rising American economy to boom and bloat in an entirely artificial and unsustainable manner for the better part of 15 years. The exigencies of war finance also transformed the nascent Federal Reserve into an incipient central banking monster in a manner wholly opposite to the intentions of its great legislative architect—the incomparable Carter Glass of Virginia.
During the Great War America became the granary and arsenal to the European Allies—-triggering an eruption of domestic investment and production that transformed the nation into a massive global creditor and powerhouse exporter virtually overnight.
American farm exports quadrupled, farm income surged from $3 billion to $9 billion, land prices soared, country banks proliferated like locusts and the same was true of industry. Steel production, for example, rose from 30 million tons annually to nearly 50 million tons during the war.
Altogether, in six short years $40 billion of money GDP became $92 billion in 1920—a sizzling 15 percent annual rate of gain.
Needless to say, these fantastic figures reflected an inflationary, war-swollen economy—-a phenomena that prudent finance men of the age knew was wholly artificial and destined for a thumping post-war depression. This was especially so because America had loaned the Allies massive amounts of money to purchase grain, pork, wool, steel, munitions and ships. This transfer amounted to nearly 15 percent of GDP or $2 trillion equivalent in today’s economy, but it also amounted to a form of vendor finance that was destined to vanish at war’s end.
Carter Glass’ Bankers’ Bank: The Antithesis Of Monetary Central Planning
As it happened, the nation did experience a brief but deep recession in 1920, but this did not represent a thorough-going end-of-war “de-tox” of the historical variety. The reason is that America’s newly erected Warfare State had hijacked Carter Glass “banker’s bank” to finance Wilson’s crusade.
Here’s the crucial background: When Congress acted on Christmas Eve 1913, just six months before Archduke Ferdinand’s assassination, it had provided no legal authority whatsoever for the Fed to buy government bonds or undertake so-called “open market operations” to finance the public debt. In part this was due to the fact that there were precious few Federal bonds to buy. The public debt then stood at just $1.5 billion, which is the same figure that had pertained 51 years earlier at the battle of Gettysburg, and amounted to just 4 percent of GDP or $11 per capita.
Thus, in an age of balanced budgets and bipartisan fiscal rectitude, the Fed’s legislative architects had not even considered the possibility of central bank monetization of the public debt, and, in any event, had a totally different mission in mind.
The new Fed system was to operate decentralized “reserve banks” in 12 regions—most of them far from Wall Street in places like San Francisco, Dallas, Kansas City and Cleveland. Their job was to provide a passive “rediscount window” where national banks within each region could bring sound, self-liquidating commercial notes and receivables to post as collateral in return for cash to meet depositor withdrawals or to maintain an approximate 15 percent cash reserve.
Accordingly, the assets of the 12 reserve banks were to consist entirely of short-term commercial paper arising out of the ebb and flow of commerce and trade on the free market, not the debt emissions of Washington. In this context, the humble task of the reserve banks was to don green eyeshades and examine the commercial collateral brought by member banks, not to grandly manage the macro economy through targets for interest rates, money growth or credit expansion—to say nothing of targeting jobs, GDP, housing starts or the Russell 2000, as per today’s fashion.
Even the rediscount rate charged to member banks for cash loans was to float at a penalty spread above money market rates set by supply and demand for funds on the free market.
The big point here is that Carter Glass’ “banker’s bank” was an instrument of the market, not an agency of state policy. The so-called economic aggregates of the later Keynesian models—-GDP, employment, consumption and investment—were to remain an unmanaged outcome on the free market, reflecting the interaction of millions of producers, consumers, savers, investors, entrepreneurs and even speculators.
In short, the Fed as “banker’s bank” had no dog in the GDP hunt. Its narrow banking system liquidity mission would not vary whether the aggregates were growing at 3 percent or contracting at 3 percent.
What would vary dramatically, however, was the free market interest rate in response to shifts in the demand for loans or supply of savings. In general this meant that investment booms and speculative bubbles were self-limiting: When the demand for credit sharply out-ran the community’s savings pool, interest rates would soar—thereby rationing demand and inducing higher cash savings out of current income.
This market clearing function of money market interest rates was especially crucial with respect to leveraged financial speculation—such as margin trading in the stock market. Indeed, the panic of 1907 had powerfully demonstrated that when speculative bubbles built up a powerful head of steam the free market had a ready cure.
In that pre-Fed episode, money market rates soared to 20, 30 and even 90 percent at the peak of the bubble. In short order, of course, speculators in copper, real estate, railroads, trust banks and all manner of over-hyped stock were carried out on their shields—-even as JPMorgan’s men, who were gathered as a de facto central bank in his library on Madison Avenue, selectively rescued only the solvent banks with their own money at-risk.
Needless to say, these very same free market interest rates were a mortal enemy of deficit finance because they rationed the supply of savings to the highest bidder. Thus, the ancient republican moral verity of balanced budgets was powerfully reinforced by the visible hand of rising interest rates: deficit spending by the public sector automatically and quickly crowded out borrowing by private households and business.
How The Bankers’ Bank Got Hijacked To Fund War Bonds
And this brings us to the Rubicon of modern Warfare State finance. During World War I the US public debt rose from $1.5 billion to $27 billion—an eruption that would have been virtually impossible without wartime amendments which allowed the Fed to own or finance U.S. Treasury debt. These “emergency” amendments—it’s always an emergency in wartime—enabled a fiscal scheme that was ingenious, but turned the Fed’s modus operandi upside down and paved the way for today’s monetary central planning.
As is well known, the Wilson war crusaders conducted massive nationwide campaigns to sell Liberty Bonds to the patriotic masses. What is far less understood is that Uncle Sam’s bond drives were the original case of no savings? No credit? No problem!
What happened was that every national bank in America conducted a land office business advancing loans for virtually 100 percent of the war bond purchase price—with such loans collateralized by Uncle Sam’s guarantee. Accordingly, any patriotic American with enough pulse to sign the loan papers could buy some Liberty Bonds.
And where did the commercial banks obtain the billions they loaned out to patriotic citizens to buy Liberty Bonds? Why the Federal Reserve banks opened their discount loan windows to the now eligible collateral of war bonds.
Additionally, Washington pegged the rates on these loans below the rates on its treasury bonds, thereby providing a no-brainer arbitrage profit to bankers.
Through this backdoor maneuver, the war debt was thus massively monetized. Washington learned that it could unplug the free market interest rate in favor of state administered prices for money, and that credit could be massively expanded without the inconvenience of higher savings out of deferred consumption. Effectively, Washington financed Woodrow Wilson’s crusade with its newly discovered printing press—-turning the innocent “banker’s bank” legislated in 1913 into a dangerously potent new arm of the state.
Bubbles Ben 1.0
It was this wartime transformation of the Fed into an activist central bank that postponed the normal post-war liquidation—-moving the world’s scheduled depression down the road to the 1930s. The Fed’s role in this startling feat is in plain sight in the history books, but its significance has been obfuscated by Keynesian and monetarist doctrinal blinders—that is, the presumption that the state must continuously manage the business cycle and macro-economy.
Having learned during the war that it could arbitrarily peg the price of money, the Fed next discovered it could manage the growth of bank reserves and thereby the expansion of credit and the activity rate of the wider macro-economy. This was accomplished through the conduct of “open market operations” under its new authority to buy and sell government bonds and bills—something which sounds innocuous by today’s lights but was actually the fatal inflection point. It transferred the process of credit creation from the free market to an agency of the state.
As it happened, the patriotic war bond buyers across the land did steadily pay-down their Liberty loans, and, in turn, the banking system liquidated its discount window borrowings—-with a $2.7 billion balance in 1920 plunging 80 percent by 1927. In classic fashion, this should have caused the banking system to shrink drastically as war debts were liquidated and war-time inflation and malinvestments were wrung out of the economy.
But big-time mission creep had already set in. The legendary Benjamin Strong had now taken control of the system and on repeated occasions orchestrated giant open market bond buying campaigns to offset the natural liquidation of war time credit.
Accordingly, treasury bonds and bills owned by the Fed approximately doubled during the same 7-year period. Strong justified his Bernanke-like bond buying campaigns of 1924 and 1927 as helpful actions to off-set “deflation” in the domestic economy and to facilitate the return of England and Europe to convertibility under the gold standard.
But in truth the actions of Bubbles Ben 1.0 were every bit as destructive as those of Bubbles Ben 2.0.
In the first place, deflation was a good thing that was supposed to happen after a great war. Invariably, the rampant expansion of war time debt and paper money caused massive speculations and malinvestments that needed to be liquidated.
The Bank of England’s Perfidy
Likewise, the barrier to normalization globally was that England was unwilling to fully liquidate its vast wartime inflation of wage, prices and debts. Instead, it had come-up with a painless way to achieve “resumption” at the age-old parity of $4.86 per pound; namely, the so-called gold exchange standard that it peddled assiduously through the League of Nations.
The short of it was that the British convinced France, Holland, Sweden and most of Europe to keep their excess holdings of sterling exchange on deposit in the London money markets, rather than convert it to gold as under the classic, pre-war gold standard.
This amounted to a large-scale loan to the faltering British economy, but when Chancellor of the Exchequer Winston Churchill did resume convertibility in April 1925 a huge problem soon emerged. Churchill’s splendid war had so debilitated the British economy that markets did not believe its government had the resolve and financial discipline to maintain the old $4.86 parity. This, in turn, resulted in a considerable outflow of gold from the London exchange markets, putting powerful contractionary pressures on the British banking system and economy.
Real Cause of the Great Depression: Collapse of the Artificial 1914-1929 Boom
In this setting, Bubbles Ben 1.0 (New York Fed Governor Benjamin Strong) stormed in with a rescue plan that will sound familiar to contemporary ears. By means of his bond buying campaigns he sought to drive-down interest rates in New York relative to London, thereby encouraging British creditors to keep their money in higher yielding sterling rather than converting their claims to gold or dollars.
The British economy was thus given an option to keep rolling-over its debts and to continue living beyond its means. For a few years these proto-Keynesian “Lords of Finance” —- principally Ben Strong of the Fed and Montague Norman of the BOE—-managed to kick the can down the road.
But after the Credit Anstalt crisis in spring 1931, when creditors of shaky banks in central Europe demanded gold, England’s precarious mountain of sterling debts came into the cross-hairs. In short order, the money printing scheme of Bubbles Ben 1.0 designed to keep the Brits in cheap interest rates and big debts came violently unwound.
In late September a weak British government defaulted on its gold exchange standard duty to convert sterling to gold, causing the French, Dutch and other central banks to absorb massive overnight losses. The global depression then to took another lurch downward.
Inventing Bubble Finance : The Call Money Market Explosion Before 1929
But central bankers tamper with free market interest rates only at their peril—-so the domestic malinvestments and deformations which flowed from the monetary machinations of Bubbles Ben 1.0 were also monumental.
Owing to the splendid tax-cuts and budgetary surpluses of Secretary Andrew Mellon, the American economy was flush with cash, and due to the gold inflows from Europe the US banking system was extraordinarily liquid. The last thing that was needed in Roaring Twenties America was the cheap interest rates—-at 3 percent and under—that resulted from Strong’s meddling in the money markets.
At length, Strong’s ultra-low interest rates did cause credit growth to explode, but it did not end-up funding new steel mills or auto assembly plants. Instead, the Fed’s cheap debt flooded into the Wall Street call money market where it fueled that greatest margin debt driven stock market bubble the world had ever seen. By 1929, margin debt on Wall Street had soared to 12 percent of GDP or the equivalent of $2 trillion in today’s economy (compared to $450 billion at present).
The Original Sub-Prime: Wall Street’s 1920s Foreign Bond Mania
As is well known, much economic carnage resulted from the Great Crash of 1929. But what is less well understood is that the great stock market bubble also spawned a parallel boom in foreign bonds—-a specie of Wall Street paper that soon proved to be the sub-prime of its day. Indeed, Bubbles Ben 1.0 triggered a veritable cascade of speculative borrowing that soon spread to the far corners of the globe, including places like municipality of Rio de Janeiro, the Kingdom of Denmark and the free city of Danzig, among countless others.
It seems that the margin debt fueled stock market drove equity prices so high that big American corporations with no needs for cash were impelled to sell bundles of new stock anyway in order to feed the insatiable appetites of retail speculators. They then used the proceeds to buy Wall Street’s high yielding “foreign bonds”, thereby goosing their own reported earnings, levitating their stock prices even higher and causing the cycle to be repeated again and again.
As the Nikkei roared to 40,000 in the late 1980s, the Japanese were pleased to call this madness “zaitech”, and it didn’t work any better the second time around. But the 1920s version of zaitech did generate prodigious sums of cash that foreign borrowers cycled right back to exports from America’s farms, mines and factories. Over the eight years ending in 1929, the present day equivalent of $1.5 trillion was raised on Wall Street’s red hot foreign bond market, meaning that the US economy simply doubled-down on the vendor finance driven export boom that had been originally sparked by the massive war loans to the Allies.
In fact, over the period 1914-1929 the U. S. loaned overseas customers—-from the coffee plantations of Brazil to the factories of the Ruhr—-the modern day equivalent of $3.5 trillion to prop-up demand for American exports. The impact was remarkable. In the 15 years before the war American exports had crept up slowly from $1.6 billion to $2.4 billion per year, and totaled $35 billion over the entire period. By contrast, shipments from American farms and factors soared to nearly $11 billion annually by 1919 and totaled $100 billion—three times more—over the 15 years through 1929.
So this was vendor finance on a vast scale——reflecting the exact mercantilist playbook that Mr. Deng chanced upon 60 years later when he opened the export factories of East China, and then ordered the People’s Bank to finance China’s exports of T-shirts, sneakers, plastic extrusions, zinc castings and mini-backhoes via the continuous massive purchases of Uncle Sam’s bonds, bills and guaranteed housing paper.
Our present day Keynesian witch doctors antiseptically label the $3.8 trillion that China has accumulated through this massive currency manipulation and repression as “foreign exchange reserves”, but they are nothing of the kind. If China had honest exchange rates, it reserves would be a tiny sliver of today’s level.
In truth, China’s $3.8 trillion of reserves are a gigantic vendor loan to its customers. This is a financial clone of the $3.5 trillion equivalent that the great American creditor and export powerhouse loaned to the rest of the world between 1914 and 1929.
Needless to say, after the October 1929 crash, the Wall Street foreign bond market went stone cold, with issuance volume dropping by 95 percent within a year or two. Thereupon foreign bond default rates suddenly soared because sub-prime borrowers all over the world had been engaged in a Ponzi—-tapping new money on Wall Street to pay interest on the old loans.
By 1931 foreign bonds were trading at 8 cents on the dollar—-not coincidentally in the same busted zip code where sub-prime mortgage bonds ended up in 2008-2009.
Still, busted bonds always mean a busted economic cycle until the malinvestments they initially fund can be liquidated or repurposed. Thus, the 1929 Wall Street bust generated a devastating crash in US exports as the massive vendor financed foreign demand for American farm and factory goods literally vanished. By 1933 exports had slipped all the way back to the $2.4 billion level of 1914.
1929-1933 Foreign Bond and US Export Bust: True Source of the Great Depression
That’s not all. As US export shipments crashed by 70 percent between 1929 and 1933, there were ricochet effect throughout the domestic economy.
This artificial 15-year export boom had caused the production capacity of American farms and factories to become dramatically oversized, meaning that during this interval there had occurred a domestic capital spending boom of monumental proportions. While estimated GDP grew by a factor of 2.5X during 1914-1929, capital spending by manufacturers rose by 7X. Auto production capacity, for example, increased from 2 million vehicles annually in 1920 to more than 6 million by 1929.
Needless to say, when world export markets collapsed, the US economy was suddenly drowning in excess capacity. In short order, the decade-long capital spending boom came to a screeching halt, with annual outlays for plant and equipment tumbling by 80 percent in the four years after 1929, and shipments of items like machine tools plummeting by 95 percent.
Not surprisingly, in the wake of this drastic downshift in output, American business also found itself drowning in excess inventories. Accordingly, nearly half of all production inventories extant in 1929 were liquidated by 1933, resulting in a shocking 20 percent hit to GDP—a blow that would amount to a $3 trillion drop in today’s economy.
Finally, Bubbles Ben 1.0 had induced vast but temporary “wealth effects” just like his present day successor. Stock prices surged by 150 percent in the final three years of the mania. There was also an explosion of consumer installment loans for durable goods and mortgages for homes. Indeed, mortgage debt soared by nearly 4X during the decade before the crash, while boom-time sales of autos, appliances and radios nearly tripled durable goods sales in the eight years ending in 1929.
All of this debt and wealth effects induced spending came to an abrupt halt when stock prices came tumbling back to earth. Durable goods and housing plummeted by 80 percent during the next four years. In the case of automobiles, where stock market lottery winners had been buying new cars hand over fist, the impact was especially far reaching. After sales peaked at 5.3 million units in 1929, they dropped like a stone to 1.4 million vehicles in 1932, meaning that this 75 percent shrinkage of auto sales cascaded through the entire auto supply chain including metal working equipment, steel, glass, rubber, electricals and foundry products.
Thus, the Great Depression was born in the extraordinary but unsustainable boom of 1914-1929 that was, in turn, an artificial and bloated project of the warfare and central banking branches of the state, not the free market. Nominal GDP, which had been deformed and bloated to $103 billion by 1929, contracted massively, dropping to only $56 billion by 1933.
Crucially, the overwhelming portion of this unprecedented contraction was in exports, inventories, fixed plant and durable goods—the very sectors that had been artificially hyped. These components declined by $33 billion during the four year contraction and accounted for fully 70 percent of the entire drop in nominal GDP.
So there was no mysterious loss of that Keynesian economic ether called “aggregate demand”, but only the inevitable shrinkage of a state induced boom. It was not the depression bottom of 1933 that was too low, but the wartime debt and speculation bloated peak in 1929 that had been unsustainably too high.