Norman, Strong, and Greenspan
Confronted with a slumping economy that threatens to get worse, Alan Greenspan, like his predecessors in the 1920s, is making all the wrong choices and failing to learn from history.
Back in July 1927, Governor Montagu Norman's problems at the Bank of England were mounting. Great Britain was stripped of its assets in the Great War and of its entrepreneurial vitality by the political shift to the welfare state. Universal unemployment insurance was introduced in 1920. Norman was struggling to cope with the high parity at which it had stabilized the pound in 1925.
Under the classical gold standard, such as prevailed before the Great War, if Britain were to suffer an external deficit, the bank would have been forced to raise rates and restrict credit until domestic costs had adjusted and a new equilibrium was established.
Under the bastardized gold-exchange standard, which was instituted in the '20s, the bank enjoyed a deal of flexibility, reducing the gold cover by persuading foreign creditors—in particular the Banque de France—to leave the money unconverted in sterling balances deposited in London. Thus, as under Bretton Woods' de jure and today's de facto arrangements, the reserve currency nations could expand credit almost beyond limit.
Norman was a man like our beloved Mr. Greenspan, always talking a tough fight against inflation, but ever wedded in reality to finding excuses for keeping money cheap. By 1927, though, he was increasingly desperate to maintain his policies and, knowing French accommodation was becoming exhausted, turned for help, as he habitually did, to his soul mate, Ben Strong at the New York Fed.
That summer, Strong and Norman summoned Schact of the Reichsbank and Rist of the Banque de France to a conference at which it was proposed that they all increase credit together, so avoiding the foreign exchange limitations to the desired inflation. The continentals, however, demurred, promising only to buy any gold they required in New York, rather than London; but before they had even embarked for the journey home, Strong and Norman acted in their despite.
Strong blithely told Rist that he was going to administer a "little coup de whiskey to the stock market." He bought sterling bills (i.e., sold the dollar), engaged in a hefty series of open market purchases of Treasuries, and lowered first the acceptance credit buying rate and finally the discount rate (this last not without a struggle against the Chicago Fed).
Adolph Miller of the FRB subsequently testified to the Senate Banking Committee in 1931 that this episode constituted "the greatest and boldest operation ever undertaken by the Federal Reserve System and, in my judgement resulted in one of the most costly errors committed by it or any other banking system in the last 75 years."
From this point on, the asset inflation of the New Era intensified, the imbalances and overexposure were increased, and the crash of '29 was written in the stars. Having declined 5 percent in June to touch back upon the previous year's highs, the Dow powered onward for the next twenty-six months to peak out on Labor Day 1929 at 381 after a gain of 130 percent, largely ignoring the 150 bps tightening in the discount rate the following spring.
As Benjamin Anderson, the highly influential chief economist at the mighty Chase Bank from 1920 to 1937, said of that belated and ineffective attempt at restraint,
"the Fed . . . were using measures which on the basis of their past experience should have sufficed to stop the stock market boom, but the boom went on. There was a new factor in the situation. The public had taken the bit between its teeth. The rise in stock market prices and the lure of stock market profits had caught the public imagination. The change in Fed policy met with an overpowering increase in the demand for money."
Industrial production took until October to respond—after a decline from March's highs—but then rallied 25 percent to its peak in July 1929, topping out just before the Great Bull Market itself would expire and embarking thereafter on a sickening decline.
Now skip to autumn 1998, when the world economy, still racked by the problems of the Asian credit bust over the preceding year, then had to cope with the Russian default and the implosion of the mighty Long-Term Capital Management.
Once again, a Fed chairman—acting in camera and, not for the first time, with no regard to due process or constitutionality—flooded the U.S. with money in order to help foreign countries, rather than setting rates in the best interests of his own nation (a futile task anyway, but we will here let that pass).
In this, Greenspan, like his predecessor, was lulled into complacency by the appearance of broadly defined price stability in the market for goods and labor (partly due to enhanced productivity and partly due to depressed import prices), and he was supported in this with enthusiasm by both the White House and the U.S. Treasury.
Over the next eighteen months, the Fed added $55 billion to its portfolio of Treasuries and swelled repos held from $6.5 billion to $22 billion (it has added another $21 billion in outrights since). Given vastly reduced modern-day reserve requirements and banks' technologically enhanced reliance on nonreservable liabilities, this translated into a combined money market mutual fund and commercial bank asset increase of $870 billion to the market peak, of $1.2 trillion to the industrial production peak, and of $1.8 trillion to date—twice the level of real GDP added in the same interval.
Notice that, like in 1928, though the Fed eventually reversed its initial rate cuts, the expansion went on unchecked for some time. Credit may have been dearer, but it was certainly no less plentiful. In the 1920s, broker loans grew 110 percent in the twenty-seven months to the market peak: in the 1990s, with near-perfect resonance, NYSE margin debt rose 114 percent from October 1998 to the March 2000 zenith. Irrational exuberance is not a modern phenomenon.
Of course, we should only look for history to rhyme, not repeat, but while many people have sought to superimpose the stock market charts for 1929 America or 1989 Japan on last year's Nasdaq, it is perhaps the similarities in production that should arrest us now that the Bubble has popped.
Since the Fed's bailout of Mexico in 1995, and against the backdrop of Japan's ongoing generation of unprecedented levels of central banking liabilities to help support its profligate recourse to deficit finance, combined with the ECB's utter incomprehension of its role in the wider world since EMU, the whole sorry history of the last six years is one of building up huge new swathes of debt on the top of older ones. All the while, we deluded ourselves that the composition of growth stimulated by this and the concomitant rise in asset prices were supportable.
Once this was revealed as a massive, almost worldwide miscalculation, rather than confess the error and work diligently to overcome it honestly, the same old prescriptions of monetary effusion have been administered everywhere, in a vain attempt to forestall the correction.