When President George W. Bush took office in January 2001, the Dow had been in decline for a year, the other markets since March. Within a month, the economy officially fell into recession. Bush responded with a mix of Keynes (tax cuts and higher government spending) and Friedman (cutting interest rates and pumping up the money supply). During that year, the Fed cut the federal funds rate 475 basis points, to 1.75 percent, and poured liquidity into the system by openmarket operations. The same remedy was applied, but with ever stronger doses, in 2002 and '03. Despite this heady dose of inflation, as well as persistent efforts to "talk up" the economy, the recession persisted into 2002 and the stock market continued to fall. The bust remained a bust, and no amount of money magic could restart the boom.
We have seen it all before.
Since the early seventeenth century, American governments (colonial, state, and federal) have tried and failed to restart business expansions by reflation. That is, they have tried to revive an inflation-driven economic boom that has stalled or collapsed by pumping new money into the system. In other words, they have tried reflating as the cure for the evils introduced by inflating. They have not yet succeeded in skipping over the inevitable contraction of the business cycle, but they have succeeded in worsening its severity and length and delaying sound recovery.
Writing in 1896, William Graham Sumner, who had studied the history of American business cycles and the political response to them, observed,
"For three hundred years our history has been marked by the alternations of 'prosperity' and 'distress' which are produced by the booms and their collapses. When the collapse comes, the people who are left long on goods and land [and stocks] always make a great outcry and start a political agitation. Their favorite device always is to try to inflate the currency and raise prices again until they can unload. . . . No scheme which has ever been devised by them has ever made a collapsed boom go up again."
With characteristic pith, Sumner pointed to the reason all such efforts had failed. "The most far-reaching vice in all these [inflation] schemes was that they led the people to believe that the methods of a 'boom' could be successfully employed in the place of the methods of thrift." In other words, the inflationists assure everyone that there is no need to save in order to fund investment--just print money and lend it out. Let us examine three case studies in the history of reflationism. For the first two, Sumner shall be our guide, for the third, the great Rothbard.
Sumner noted that from colonial days to the late nineteenth century periods of inflation were always followed by slowdowns and complaints about a shortage of money. In 1715, Massachusetts issued 100,000 pounds of paper money. The economy boomed, and then it floundered. By 1720, "there was a great cry for more bills. Let it be observed how this complaint is heard again every four or five years, although the amount of paper was continually increasing. It is the best instance in history of the way in which a country 'grows up' to any amount of currency." He coined a famous truism to sum up the lesson: "There can never be a scarcity of currency except when there is too much of it."
The United States experienced five major business cycles during the nineteenth century, each one culminating in a financial crisis and depression. The second occurred during the 1830s. From 1833 to 1837, the nation's money supply (specie plus bank notes and deposits) increased by 78 percent, or nearly 20 percent annually. The new money sparked a cotton boom in the South, a canal boom in the Middle West, and a land and real-estate boom everywhere. By early 1837, interest rates began to rise as cotton planters and canal contractors sought to borrow more capital to sustain their struggling projects. In the spring, a sudden contraction in British credit and a fall in the demand for cotton paralyzed the American economy. Large mercantile houses in New Orleans and New York failed. Interest rates skyrocketed. Prices plummeted. Thousands were thrown out of work. In May, the banks suspended specie payments. The money supply fell by 17 percent.
For once, the federal government wisely did nothing. President Martin Van Buren, a hard-money New Yorker, blamed the crisis on the "excessive issues of bank paper" and an "undue expansion of credit." His recommended course of action was to let the liquidation run its course and for the government to cease collecting or disbursing bank money and deal only in specie. To those clamoring for tariffs, public works, and federal money, he replied dryly, "All communities are apt to look to government for too much. This ought not to be."
However, the necessary liquidations, debt reductions, and reallocations of capital were arrested by the untimely intervention of the banks and the states. Taking advantage of the suspension, they began inflating again. They were led by the former central bank, the Bank of the United States, whose president, Nicholas Biddle, was determined to restart the boom by borrowing funds in Europe and using it to buy cotton. The state banks were fully supported by their governments, many of which authorized the illegal suspensions or refrained from prosecuting the delinquent banks, and all of which continued to deal in bank paper. The most indebted states even issued additional bonds. The money supply increased by 8 percent in 1838 sparking a mini-boom. It did not last long.
Panic again struck in the fall of 1839. There was another run on the banks, and all of them south and west of New York again suspended payments. Sumner wrote, "This suspension was the real catastrophe of the speculative period which preceded it. A great and general liquidation now began. . . . The stagnation of industry lasted for three or four years. The public improvements so rashly begun were suspended or abandoned." Cotton prices again fell, as did the price of stocks and real estate. Many banks failed entirely, including the powerful Bank of the United States. States defaulted on their bonds, and canal companies and other firms went bankrupt. "The revulsion was so complete that it could not be arrested until industry came almost to a standstill and took a fresh start."
The reason for the liquidation was not that the banking system was incapable of providing sufficient liquidity and credit to weather a crisis and restart the economy, but that huge debts had been contracted in Europe, the canal system was overbuilt, too much land had been brought into cotton cultivation, and land and real estate prices were inflated because of inflation-driven speculation. For the next four years the country paid the bill "for the grand times of the years before. It was like the spendthrift living low to recover his position." The country did it "by producing mainly for export, at prices low enough to suit the creditors." By 1843, "a new sound and healthy development of industry and credit began."
In 1857 by contrast, neither the banks nor the governments attempted to reflate the economy when another stock-market crisis and bank run rocked the economy in the fall. President James Buchanan, another hard-money Northerner, wisely did nothing. "It is apparent," he wrote in his first annual message, "that our existing misfortunes have proceeded solely from our extravagant and vicious system of paper currency and bank credits." For the next six months, the money supply shrunk, interest rates went up, government spending stayed constant, and businesses and banks were allowed to fail. The result? The economy was in full recovery by the spring. However, Buchanan warned in his next annual address that "these revulsions must continue to occur at regular intervals" as long as the banks were allowed to inflate the currency and extend credit beyond their actual capital reserve.
One of the most powerful, persistent, and pernicious historical myths is that the Great Depression of the 1930s resulted from the laissez-faire policies of the three Republican presidents of the 1920s. If students learn anything at all from college history, besides that slavery was bad, and Hitler was really bad, it is this. In Modern Times (1983), the historian Paul Johnson stated a corollary of this myth. It is that President Hoover, "because of his ideological attachment to laissez-faire, refused to use government money to reflate the economy and so prolonged and deepened the Depression."
Of course, Hoover held no such principles, and he did precisely what the myth faults him for not doing. Hoover was a corporatist, an inflationist, and a statist who tried every policy in the interventionist playbook. He denigrated economists who urged him to follow the examples of such laissez-faire presidents as Van Buren, Buchanan, and Cleveland as "reactionaries" and "bitter-end liquidationists" whose advice, if followed, would lead to "utter ruin." Such a passive policy was not for the "great engineer." Hoover did something. He declared "war" on the depression. It led to utter ruin.
Johnson's brilliant discussion of this period is drawn directly from Murray Rothbard's revisionist masterpiece America's Great Depression (1963). As Rothbard explains, Hoover tried all of the following to revive the economy: tax cuts in 1930; higher tariffs (the Smoot-Hawley tariff of 1930); deficit spending ($2.1 billion in 1931, and $3 billion in 1932); public works funding; subsidies for agriculture; propping up wage rates; government loans to railroads, banks and financial institutions through the Reconstruction Finance Corporation (1932); bank credit liberalization by the Glass Steagall Act (1932); a huge tax increase by the Revenue Act of 1932; and Fed pump priming. Johnson concluded, "That he sought to use government cash to reflate the economy is beyond question."
Free bankers and Chicago school monetarists, however, contend that Hoover and the Federal Reserve passively allowed the money supply to shrink and so starved the economy of the funds and credit necessary to restart ailing businesses and financial institutions. The truth is that the Federal Reserve tried to inflate but was frustrated by the public's lack of confidence in the banking system and by the bankers' reluctance to extend credit to marginal enterprises. In the weeks and months after Black Monday, the Federal Reserve both cut interest rates and poured liquidity into the banking system.
By pumping up reserves, they hoped to keep the credit boom going and revive the stock market. By the end of the year, they had lowered the discount rate from 6 to 4.5 percent, purchased $375 million in government bonds, and lent member banks $200 million. Because of these inflationary measures, the market began moving up again in November. The Hoover administration did not neglect to "talk up" the economy. Secretary of the Treasury Andrew Mellon boasted that there was "plenty of credit available," and other officials, including the president, assured the public that the crisis was over and the economy on the road to recovery. Thanks to the Federal Reserve, of course.
The Hoover Fed pursued the same course in 1930. They cut the discount rate to 2 percent and purchased another $218 million in federal securities. Despite these measures, the market resumed its downward spiral and the money supply remained constant that year. Even more vexing for Hoover and his new Fed chairman and fellow inflationist, Eugene Meyer, the money supply actually shrank in the latter half of 1931, falling from $73.2 to $68.2 billion. Despite their efforts to pump reserves into the banking system through Fed discounting and open market operations, banking reserves, and hence the money supply, were shrinking. Industrial production was falling as well. They just tried harder the next year.
In the first half of 1932, the Fed purchased $1.1 billion in federal securities and continued discounting for the member banks. However, the money supply proved recalcitrant, falling to $64.7 billion by the end of the year. Why? From the start of the Depression, the Fed's efforts were frustrated by the public's withdrawal of federal-reserve notes and gold from the banks. They had lost confidence in the system and wanted to hold more cash. Second, the banks were reluctant to lend out all their new reserves. As fractional-reserve institutions, they knew they were vulnerable to a bank run. They also doubted the solvency of many of those clamoring for more credit. It should be stressed that had the Fed not intervened in the money and credit market the money supply would have fallen even more. Furthermore, the money supply would have shrunk beginning in late 1929, instead of being delayed a full year by Fed pump priming.
We can now answer the question of why the Great Depression lasted so much longer (nearly ten years) and was so much more severe than previous depressions. Of the five nineteenth century business contractions, none lasted more than four years, and not one was marked by the sustained high levels of unemployment and sharp drops in industrial production experienced during the 1930s. If the monetarists are right that stagnation in the growth of money caused the Depression to last and grow progressively worse, then why did the far more immediate and significant shrinkages in the money supply occurring after nineteenth century panics not do the same?
During those periods, there were sharp reductions in bank deposits, bank notes, wages, and prices. Bankrupt and marginal firms, farms, corporations, and banks failed in large numbers. Banks called in loans and all but ceased new lending. However, within a short period, business and production revived, and, although times would remain "hard" for a number of years, people had little trouble finding productive work, or surviving businesses and farms borrowing money at rates of interest that reflected the supply of loanable funds and capital goods. What happened was that capital and labor was redirected from overdone or unprofitable areas to more productive and profitable ones.
This did not happen after the stock market crash of October 1929 because Hoover's proto-Keynesian fiscal policies and inflationary monetary policies drove down interest rates, kept up wage levels, prevented deflation, and delayed the liquidations and adjustments needed to lay the groundwork for a sound recovery. That such would be the result of Hoover's policies was recognized at the time by a number of writers and economists quoted by Rothbard. For example, in August 1930, Dr. Benjamin Anderson of Chase National Bank warned that the "depression has been prolonged and not alleviated by delay in making necessary readjustments." In 1933, Dr. Seymour Harris agreed that Hoover's policies had "retarded the process of liquidation … and … accentuated the depression."
It is too early to see the full consequences of the Bush-Greenspan reflation, but if the past is any guide we can expect the next decade to more resemble the 1970s than the 1990s.
