Skip to comments.Does a Falling Money Stock Cause Economic Depression?
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 millionan 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, Bobthe borrower of $100will 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.
He left out the big hitter, depression.
Interesting scenario. There is one big item that is not even mentioned, Mortgage Debt.
What role will this interloper play. It's certainly not the same as 29 with this factor.
Anyone want to take a slice at that ?
The system hasn't been permitted to clear itself of the 90's bubble. Instead, the excesses and nonproductive activities are now being supported to present the illusion that all is well. In the mean time, the underlying economy becomes weaker and weaker.
The underlying proposition here, advanced generally by present day fed economists, the monetarists (led by Dr. Milton Friedman), and the popular media, is that the depression was caused by failure of the Monetary Authorities (the Fed) to provide sufficient liquidity in the form of money supply.
The first, perhaps most important point made by the author, Frank Shostak is that this is just plain wrong on the record--it's another one of those self serving propositions that when said often enough, is accepted as fact even though a cursory examination of the real data demonstrates that it is a fraud.
Many years ago, when I was in college, the cause of the Great Depression was still a contentious issue--the lead, and best economics professor at the University was an accused card carrying Communist in the 30's because he believed that the depression was the necessary result of internal faults in the free enterprise system.
I took Economic Cycles from a visiting Harvard economics professor who parroted the same lines. However one class session was conducted by an individual who had been on the Fed staff in the 30's. He said the modern monetarist line is nonesense--"What do people think we were doing back then anyway? Did they think we were asleep? Did they think we were not reading the data?"
As a committed believer in the free enterprise system, I spent a lot of time researching to develop my own political economic understanding of what really happened.
This article only refutes the popular legend. The issue however is what in fact is the cause of the economic condition that led to the great depression and is leading to the greater depression today. The answer is clear--the data is readily available; and the analysis is simple.
The depression of the 1930's was caused by the excessive liquidity created by the fed in the 1920's. As the author points out excess liquidity resulting from injection of bank reserves gets into the economy through the debt process. In the 1920's, the principal engine was stock market margin debt--everyone was in the stock market, creating a bubble with margin debt. When it became clear that underlying values (earnings) did not support prices, prices collapsed leaving the debt to be repaid from other sources.
How does debt result in deflation? Debtors of any class, government, business, or individual, have limited liquidity. That is why the debt (borrowed liquidity) was needed in the first place. Debtor liqudity may come from tax revenues, business earnings, or monthly earned income--but it is limited. The portion of available periodic liquidity commited to payments on debt curtails liquidity for other purposes--instead of buying a new car this month, the debtor makes a payment on his new house.
There is no reliable data on what the real limits are--how much of current income can be paid on residential mortgage debt, or credit cards or whatever without creating a deflationary economic environment. Historically, mortgage lenders had rules of thumb however we have now exceeded those limits significantly.
Point is that in the macro economy, you reach a point where aggregate debt service by government, business and individuals consumes so much of periodic liquidity that the entity involved can no longer afford to make additional purchase commitments. Buyers disappear.
In the business environment, pricing power disappears and prices begin to drop; so do profits. Tax revenues drop because they are based on economic activity (income and spending). Jobs disappear; or compensation on continuing employement drops.
Deflation becomes imbedded--because new debt is incurred, not to buy additional assets but instead to make payments on existing debt.
Mortgage debt and the housing market? What has happened is that the users of residential real estate no long have enough current liquidity to pay for the right to use the asset at current market prices which have been inflated by excess available credit to marginally qualified buyers. There are other factors at work in the housing market--property taxes and insurance, both based on the inflated bubble price and taxes raised to support expansionary economy levels of government activity that no longer are required. So we have skipped payments; interest only months; rising default rates and mortgage foreclosures. Monthly payments are made with additional credit card debt. A general decline in market prices is probably not too far ahead.
This is a fair summary of the current economic environment. As Shostak points out, the historical experience is that additional lending has been counterproductive (in the US in the 30's; and in Japan). Reason why is of course set out above.
How do we get out of this mess? Well you have to see how people get additional liquidity other than through the debt process. You have to expect new jobs to be created and employment to go up; compensation has to go up; business income has to go; tax receipts must go up. If anybody sees any positive signs on any of these items, or if anybody can see any reason why any of these things might happen, they should post immediately. I don't.
Worst Stock Market Crashes
The 10 worst stock market crashes in U.S. History.
1932 - 1933 Stock Market Crash
The 10th worst stock market crash in U.S. History.
To find out 10th worst market crash, I had to dig back in the DJIA records all the way back to the 1930s. This crash barely beat out the 1987 stock market crash (loss of 36.1%) - a crash that most of us are more familiar with.
Date Started: 9/7/1932
Date Ended: 2/27/1933
Total Days: 173
Starting DJIA: 79.93
Ending DJIA: 50.16
Total Loss: -37.2%
1916 - 1917 Stock Market Crash
The 9th worst stock market crash in U.S. History.
If the 1930s sounded like a long time ago, well to find the 9th worst market crash, I had to go back to the WWI era.
It's difficult to break even after a 40% loss. On a $1,000 investment, your portfolio went down to $600. To get back to $1,000, it would have to go up 66.7%!
Date Started: 11/21/1916
Date Ended: 12/19/1917
Total Days: 393 Starting DJIA: 110.15
Ending DJIA: 65.95
Total Loss: -40.1%
1939 to 1942 Stock Market Crash
The 8th worst stock market crash in U.S. History.
Although this stock market crash only took the 8th spot, it is the longest one on our list, lasting nearly 3 years! With WWII and the attack on Pearl Harbor, the markets had a very tough time.
Date Started: 9/12/1939
Date Ended: 4/28/1942
Total Days: 959
Starting DJIA: 155.92
Ending DJIA: 92.92
Total Loss: -40.4%
1973 - 1974 Stock Market Crash
The 7th worst stock market crash in U.S. History.
Another long market crash - one that many people still remember (think Vietnam and the Watergate scandal). This crash lasted for 694 days before bottoming out.
Date Started: 1/11/1973
Date Ended: 12/06/1974
Total Days: 694
Starting DJIA: 1051.70
Ending DJIA: 577.60
Total Loss: -45.1%
1901 - 1903 Stock Market Crash
The 6th worst stock market crash in U.S. History.
This is the oldest crash to make the list
Date Started: 6/17/1901
Date Ended: 11/9/1903
Total Days: 875
Starting DJIA: 57.33
Ending DJIA: 30.88
Total Loss: -46.1%
1919 - 1921 Stock Market Crash
The 5th worst stock market crash in U.S. History.
This crash followed a post war boom (Stock prices rose 51%). After the crash bottomed out in August of 1921, this decade saw tremendous growth in the stock market and the economy (often called the roaring twenties).
Date Started: 11/3/1919
Date Ended: 8/24/1921
Total Days: 660
Starting DJIA: 119.62
Ending DJIA: 63.9
Total Loss: -46.6%
1929 Stock Market Crash
The 4th worst stock market crash in U.S. History.
Although this is the shortest market crash observed, it was a deadly one. Investors saw almost half their money disappear in just two months. This crash kicked off what we now know as the "Great Depression."
Date Started: 9/3/1929
Date Ended: 11/13/1929
Total Days: 71
Starting DJIA: 381.17
Ending DJIA: 198.69
Total Loss: -47.9%
1906 - 1907 Stock Market Crash
The 3rd worst stock market crash in U.S. History.
This crash was called the "Panic of 1907." The U.S. Treasury department bought 36 million dollars worth of government bonds to offset the decline (and remember, $36 million translates to a much bigger number in today's dollars).
Date Started: 1/19/1906
Date Ended: 11/15/1907
Total Days: 665
Starting DJIA: 75.45
Ending DJIA: 38.83
Total Loss: -48.5%
1937 - 1938 Stock Market Crash
The 2nd worst stock market crash in U.S. History.
Just when investors thought the market was finally good again, following a recovery of almost half of the great depression losses, the market plunged again due to war scare and Wall street scandals.
Date Started: 3/10/1937
Date Ended: 3/31/1938
Total Days: 386
Starting DJIA: 194.40
Ending DJIA: 98.95
Total Loss: -49.1%
Worst Market Crash Ever (1930 to 1932)
The worst stock market crash ever in U.S. History.
This is the grand daddy of them all. Investors lost 86% of their money over this 813 day beast. This market crash combined with the 1929 crash, makes up the great depression.
If you had $1000 on 9/3/1929 (beginning of the 4th worst crash, it would have gone down to a whopping $108.14 by July 8th, 1932 (end of the worst crash) or an 89.2% loss. To recover from a loss like that, you would have to watch your portfolio go up 825%! The full recovery didn't take place until 1954, 22 years later!
Date Started: 4/17/1930
Date Ended: 7/8/1932
Total Days: 813
Starting DJIA: 294.07
Ending DJIA: 41.22
Total Loss: -86.0%
.....yes, and my hunch is that the triggering event will be a rate cut....we've had 12 already with lack luster results.....the Fed is running out of ammo and if they keep cutting eventually people will say "nothings working....I'm getting out while I still can"....IMHO that's when the stampede will begin....I expect it will be much worse than the great Depression for 2 reasons....a)people didn't have big debt back then...b)about 40% of the population lived on farms so they could make do to some degree.
Like you Billy Bob, I hope I'm wrong about this
Good luck to everyone!
Stonewalls the Ant