Where Did All The Money Go? Part IV: Those Who Cannot Remember the Past George H. Blackford (2011) (Revised 1/18/12)

The 1920s began with a mild recession in 1920-1921 followed by a speculative bubble in the real estate market. The real estate bubble burst in 1926 and was superseded by a speculative bubble in the stock market. There was a mild economic downturn in 1927, a brief recovery that same year, and another mild downturn in the summer of 1929. Then the stock market bubble that began in 1926 came to a dramatic climax in the fall of 1929. (Galbraith Friedman Meltzer)

The Crash of 1929 began October 24—a day that became known as Black Thursday— when stock prices dropped dramatically in the morning and recovered somewhat in the afternoon. While prices rallied the following day, there were two more black days to come: October 28, Black Monday, when the Dow Jones Industrial Average fell 12.8% and October 29, Black Tuesday, when the Dow fell an additional 11.7%. Overall, the stock market fell by 80% from its high in 1929 to its low in 1932 as the Dow lost almost 90% of its value.

As stock prices fell in the fall of 1929, the mild recession that had begun in the summer became severe, and a banking crisis began in 1930 that reached its climax in 1933 when some 4,000 banks and 1,700 savings and loans went under in that year alone. By the time the crisis came to an end some 10,000 banks had gone out of business along with 129,000 other businesses, and we were in the depths of the Great Depression.

The Great Depression of the 1930s

From 1929 through 1933, unemployment went from 1.6 million to 12.8 million as the unemployment rate jumped from 3.2% of the labor force to 24.9%. The economy experienced a major deflation as consumer prices fell by 25% and wholesale prices by 30%. The total value of goods and services produced in the United States fell by 46% 2

while the level of production fell by over 30%. Just as happened in 2008, the financial crisis in the United States spread throughout the rest of the world, and the entire world faced an economic catastrophe of epic proportions.

The depression lasted more than ten years. There were still 8.1 million people unemployed in 1940, and the unemployment rate did not fall below 14% until 1941. It wasn't until 1943—when the economy was fully mobilized for World War II—that the unemployment rate finally fell to its 1929 level, and by then the United States had increased the size of its military by over 8.5 million soldiers. In other words, we did not solve the unemployment problem created by the Great Depression until we were fully mobilized for World War II and had drafted a number of people into the military comparable to the number who were unemployed in 1940. (Figure 1)

Figure 1: Rate of Unemployment, 1929-2010.

Source: Economic Report of the President, 2011. ( B35PDF-XLS 1967 B20PDF) What Went Wrong

It was clear to most people at the time that the cause of the problem was rampant speculation in the stock market financed by expanding debt. In fact, the debt created by the financial system during the 1920s had grown to unreasonable levels in all areas, not just in the stock market. This debt was unsustainable, and the stock market crash was 3 just the trigger that set in motion a set of forces that, in the face of this debt, brought down the entire economic system. (Fisher)

When the stock market crashed, the value of stocks that provided the collateral for speculative loans fell. This led to a panic in the financial sector as financial institutions tried to cut their losses by recalling existing loans and refusing to make new loans, not just loans collateralized by stocks but all loans. The financial system simply froze, and credit became unavailable. This forced debtors whose loans were called or who could not refinance their loans when they came due to sell the collateral underlying their debts as well as other assets in order to meet their obligations. These forced sales of collateral and other assets, in turn, caused asset prices to fall throughout the financial system, and debtors began to default as the value of their assets fell below the value of the loans they had to repay. (Fisher)

As the panic grew, businesses that were unable to finance their inventories and payrolls for lack of credit were forced to cut back their operations and layoffs began. At the same time, households that were unable to finance the purchase of such things as new homes, automobiles, and other durable goods for lack of credit were forced to cut back their expenditures. As output, employment, and business and household expenditures fell, income fell as well. The rise in uncertainty and the heightened sense of fear and pessimism toward the future exacerbated the situation. The result was a vicious spiral downward as falling output and employment led to falling income and expenditures which, in turn, led to falling output and employment. (Keynes)

All of this should sound familiar, given our experience during the current crisis, since this is exactly what happened in the mortgage market following the bursting of the housing bubble in 2007 and the financial sector grinding to a halt in September of 2008. Debt in the American economy had grown to unsustainable levels by 2007, and when the housing market crashed, the value of the real estate that provided the collateral for real estate loans fell. This led to a panic in the financial sector as financial institutions tried to cut their losses by recalling existing loans and refusing to make new loans, not just loans collateralized by real estate but all loans. The financial system simply froze, 4

and credit became unavailable. This led to the same kind of forced selling of collateral and other assets that, in turn, caused asset prices to fall that we saw following the stock market crash in 1929. It also initiated the same kind of vicious downward spiral in output and employment in 2008 and 2009 that the economy experienced in 1930 through 1933 with falling output and employment leading to falling income and expenditures which, in turn, led to falling output and employment. (FCIC WSFC) There were some fundamental differences, however.

Following the stock market crash in 1929, a run on the banking system began that led to the banking crisis in 1930 as people began taking money out of the banks in an attempt to protect their savings by hoarding cash. At the same time, the Federal Reserve was both unwilling and unable to react appropriately to the deteriorating situation. This, in turn, caused the money supply to fall by 25% from 1929 to 1933 which, combined with the fall in output and employment, caused wages and prices to fall as well. The resulting deflation caused the debt that had been accumulated during the 1920s to become an overwhelming burden since this debt now had to be repaid in the face of falling wages, prices, and incomes. To make things worse, wages and prices fell more rapidly than the debt could be liquidated which caused the real burden of the debt to increase even as the total debt fell. (Fisher)

In short, because of the unsustainable level of debt that had accumulated during the 1920s and the inability and unwillingness of the Federal Reserve to act, as debtors found themselves unable to meet their contractual obligations the contract system within the financial system broke down; widespread bankruptcy followed, and the financial system simply imploded. It was this implosion of the financial system—brought on by an unsustainable level of debt combined with falling output, income, money supply, wages, and prices—that brought down the rest of the economy and created the Great Depression of the 1930s. (Fisher Keynes Friedman Meltzer)

The Fall and Rise of Ideology

The vast majority of our political leaders entered the 1930s with an abiding faith in the nineteenth century ideology of free market capitalism. They were convinced that 5

markets were self correcting, attempts at government intervention would do more harm than good, and that if the economy was just left to its own devices competition in free markets would allow wages and prices to adjust to bring the economic system back to full employment. Some even believed the economic system would be made better by the experience of a depression in that depressions weeded out economically inefficient firms and, thereby, made the economy more productive. The experience of the 1930s provided a shocking dose of reality.

With total output falling by 30%, the unemployment rate increasing to 25%, tens of thousands of business going bankrupt, and human misery increasing at an accelerating rate, it was impossible for economists to explain just how the economic system was going to be made better by all of this or why the government should not be allowed to intervene to do something about it. There had to be something wrong with an ideological theory that proclaimed it was a good thing for society to be going through what it was going through at the time. The only explanation the theory could offer for the dismal unemployment statistics was that wages were not falling fast enough to bring the system back to full employment. But by 1933, wages had already fallen by 22% in manufacturing, 26% in mining, and 53% in agriculture.

There was obviously something wrong with the theory, and all but those with the most blind ideological faith in the miraculous powers of free markets could see that there was something wrong with the theory.

The Crash of 1929 was not the first financial crisis brought on by rampant speculation and reckless behavior in our financial system. As was noted above, there were crises in 1819, 1837, 1857, 1873, 1893, and 1907 that led up to 1929, and the economic fallout from each seemed to be worse than the one that came before. The Great Depression that followed the Crash of 1929 was the straw that broke the camel’s back, and, in response, our political leaders of the 1930s through the 1960s abandoned the failed nineteenth century ideology of free market capitalism in favor of a pragmatic regime of regulated market capitalism. This led to the creation of an elaborate system of regulatory and supervisory institutions designed to keep our financial institutions in 6

check. It also led to the elaborate system of government sponsored social insurance programs we have today—Social Security, Medicare, Medicaid, Supplemental Security Income, Temporary Assistance to Needy Families, Unemployment Compensation, and various food and housing assistance programs—programs that were designed to alleviate the sufferings caused by the vagaries endemic in our economic system. These systems actually worked for some fifty years to accomplish their ends, and in the case of our social insurance programs are still working today.

Unfortunately, as new generations replaced old and memories of the 1920s and Great Depression faded, an antigovernment movement began to take hold in the 1970s, and the failed nineteenth century ideology of free market capitalism became fashionable among our political leaders again. As a result, the regulatory and supervisory system that served us so well since 1929 was systematically dismantled to the point that it was virtually gutted by the early 2000s. This made it possible for our financial institutions to repeat the folly of the 1920s and drive our nation—along with the rest of the world—into another economic catastrophe of epic proportions, just as these institutions had done in the 1920s.

How We Survived

The most fundamental difference between today and the 1930s is that, so far at least, we have been able to minimize the kind of fallout from the financial crisis of 2008 that had such devastating effects on the economy as well as on the lives of so many people in the 1930s, and all that has saved us from this kind of devastation is Big Government. This may seem counterintuitive in today’s world with so much hate-filled antigovernment rhetoric out there, but the simple fact is there are but three threads by which our economic system is hanging today that have saved us from the fate our country went through in the 1930s. And these threads are there only because of the size of our federal government.

Government Outlays

The first is the level of federal government expenditures. Figure 2 shows these 7 expenditures from 1930 through 2010, both in absolute amounts and as a percent of GDP. These expenditures increased during the current crisis from $2.7 trillion in 2007 to $3.7 trillion in 2010 and in the process went from 19.4% to 25.8% of GDP. Federal government expenditures are helping to save us because they create incomes for people, and without the resulting incomes they have created we most certainly would have experienced a much greater level of unemployment than the peak of 10.1% we obtained following the financial system’s grinding to a halt in the fall of 2008.

Figure 2: Federal Government Outlays, 1929-2010.

Source: Office of Management and Budget. (1.2) Bureau of Economic Analysis. (1.1.5)

The reason is that the incomes provided by federal government outlays helped to short- circuit the vicious downward spiral of falling income, output, and employment that wrought such havoc from 1929 through 1933, because when federal government 8

outlays went up, the incomes created by federal government outlays went up as well. This increase in government created income partially offset the fall in incomes from other sources. If the incomes generated from federal outlays had fallen along with other incomes, the downward spiral that began in 2007 and accelerated dramatically in 2008 and 2009 would have been, beyond any doubt, far worse than it actually turned out to be. The stability of federal government outlays in the face of the economic decline provided a powerful brake on the economy as it spiraled downward during the current crisis.

The situation was much different in 1929 through 1933. Federal government expenditures were less than 4% of GDP in 1929 and were only 8.0% of GDP in 1933. What’s more, because of the ideological faith economists had in the self-correcting nature of the economy, total government expenditures were actually allowed to fall by 5.9% during this period as state and local governments were forced to cut back for lack of support from the federal government. As a result, federal government expenditures played a much smaller role in stabilizing the economy as it spiraled downward from 1929 through 1933 than they did during the current crisis.

Federal Reserve Policy

The second thread by which the economy is hanging today is the actions taken by the Federal Reserve that kept the financial system from imploding. By accumulating unprecedented levels of assets on its balance sheet, and through direct loans to financial institutions and other businesses, the Federal Reserve made available unprecedented levels of reserves to the financial system throughout the entire world.

The extraordinary nature of the Fed’s actions in this regard is shown in Figure 3 where Federal Reserve Bank Credit can be seen to increase from $895 billion in August of 2008 to $2.2 trillion by December of that year—an increase of 146% in just four months.

Even if you do not understand how the financial system works, it should be obvious from looking at Figure 3 that something went terribly wrong back in the fall of 2008 and that the actions taken by the Fed at that time were not only unprecedented, they were 9

Figure 3: Federal Reserve Bank Credit January 2003-August 2011.

Source: Federal Reserve Statistical Release. truly desperate. It should also be obvious that the financial crisis that reached a climax in 2008 is not over. The Fed increased its credit from $907 billion at the beginning of 2008 to over $2.2 trillion by the end of that year, and most of that increase took place in the last four months of 2008. In August 2011 Federal Reserve Bank credit stood at $2.8 trillion after QE2. This crisis won’t be over until that number gets back to somewhere in the one trillion dollar range it started at before the crisis began.

Without the actions taken on the part of the Federal Reserve to increase reserve bank credit in 2008, our financial system most certainly would have collapsed, and the unemployment rate we face today most certainly would have been far above 10%. In addition, because the American dollar serves as the single most important reserve currency for international transactions throughout the world, the collapse of our financial system would have brought down the entire international financial system. By maintaining those reserves the Fed has been able to prevent a total collapse of both the domestic and the international financial systems. As a result, we have been able to avoid, so far at least, the kinds of consequences suffered in the 1930s from the collapse of these systems, namely, a falling money supply combined with dramatically falling wages and prices that led to the debt-deflation described by Irving Fisher in 1932 and 10

1933.

Again, the situation was much different in 1929 through 1933. While the Fed did increase reserve bank credit by 66% during this period, it took four years rather than four months to do so. What’s worse, because of its ideological faith in the self-correcting nature of free markets, the Federal Reserve actually allowed reserve bank credit to fall by 25% during the crisis in 1930. In addition, the Federal Reserve lacked the legal authority to intervene in the economic system in 1933 that the Fed has today as a result of the regulatory legislation enacted after 1933.

To make matters worse, there was no international reserve currency at the time that could be increased to deal with the international financial crisis that developed. There was only gold, and, as a result, the entire international financial system disintegrated. All of these factors combined to cause the international financial system to collapse, more than 10,000 banks to go out of business in the United States, the money supply to fall by 25%, and the economy to experience a major deflation which exacerbated the fall in output, income, and employment from 1929 through 1933. (Fisher Friedman Meltzer)

Social Insurance Programs

The third thread by which our economy is hanging today—one that has been essential to keeping us from suffering the kinds of deprivations and hardships that were so widespread in the 1930s—is the fact that a major portion of our federal government’s budget is directly related to social insurance programs. These programs fall under the headings of Social Security, Medicare, Health (Medicaid, health research, and occupational health and safety), and Income Security (retirement and disability benefits for federal employees, Supplemental Security Income, unemployment compensation, housing assistance, and food and nutrition assistance) in the federal budget. In 2010, expenditures in these categories summed to $2.1 trillion and comprised 62.2% of the total government outlays.

There can be no doubt that the index of human misery and suffering that exists today as a result of the economic catastrophe brought on by the fraudulent, irresponsible, and 11

reckless behavior of our financial institutions would have been immeasurably worse had it not been for these $2.1 trillion of federal government social insurance expenditures that did not fall during this catastrophe but actually went up.

Without the $706.7 billion spent by the Social Security Administration, some 54 million people who are receiving benefits from Social Security today would not have these benefits to fall back on. Without $820.7 billion spent by the federal government on Medicare, Medicaid, veterans health benefits, and on other federal health programs the entire healthcare system in the country would have collapsed—just as it did in the 1930s when people actually were forced to trade chickens for healthcare—with all of the increased human misery and suffering that would have entailed. Without the $622.2 billion spent by the federal government under the heading of Income Security in the federal budget countless millions more people would be in dire straits compared to what we see today.

There was no Social Security in 1929; no Medicare, Medicaid, or veteran’s health benefits; no disability insurance or unemployment compensation; no food and nutrition or housing assistance programs. When the speculators and bankers combined to bring down the system back then, people were left on their own to fend as best they could, and the result was suffering and misery far beyond anything we see today. It was because of the immense personal hardship and suffering brought on by the depression that the federal government was forced to step in, and the Federal Emergency Relief Administration, Civilian Conservation Corps, and Works Progress Administration came into being in the 1930s. And it was because of the immense personal hardship and suffering brought on by the depression that the social insurance programs that are saving us today were brought into being.

Some idea of the difference the size of the federal government, its social insurance programs, and the Fed’s actions made during the current crisis and that of the 1930s can be gleaned from the unemployment rates from 1929 through 2010 plotted in Figure 1. We haven’t even come close today to going through what we went through in the 1930s. At least not yet. 12

These three threads—rising federal government expenditures, the heroic actions of the Federal Reserve, and the social insurance programs provided by the federal government—are all that has kept our economy from spiraling into the abyss it spiraled into in the 1930s, and in the Alice-in-Wonderland world in which we live today, free market ideologues are still chanting their mantra of lower taxes, less government, and deregulation as they do everything within their power to cut these threads. What’s more, given the political climate that exists today there is every reason to believe they may succeed in doing so. (Turgeon)

Part V: Mass Production, Income, Exports, and Debt