The Dark Side Part IV Chapter IV - Fritz the Cat

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But now for some excerpts from a Monetary History of United States, 1867 to 1960 by Milton Friedman and Anna Jacobson Schwartz.

(Page 17)  Throughout our analysis, we shall have occasion to divide the money stock into two main components: currency and deposits…  currency is either specie or direct or indirect obligation of the government; deposits have been an obligation of privately owned and operated banks that have been legally required to hold assets in the form of currency or its equivalent equal to a fraction of their liabilities.

(Page 50)  In such a system, it is useful to distinguish three major channels through which any change in the stock of money must, as a matter of arithmetic, occur.  Number one.  High powered money: the total amount of hand to hand currency held by the public plus vault cash plus, after 1914, deposit liabilities of the Federal Reserve System to banks.  The final two items constitute bank reserves.  The total is called high powered money because $1.00 of such money held as bank reserve may give rise to several dollars of deposits….  Any increase in the total of high powered money involves an equal percentage increase in the stock of money.  Number two. The ratio of commercial bank deposits to bank reserves.  Number three.  The ratio of commercial bank deposits to currency held by the public:  the higher this ratio, the larger than the fraction of high powered money that will be in use as bank reserves, and hence the larger the money stock.

Paid a 52.  In a specie (gold) standard the quantity of money in a country is mechanically linked to the amount of specie held.  Under an international species standard, the amount in one country must be whatever is necessary to maintain international balance with other countries on the same the standard, and the amount of high powered money will alter through imports and exports of specie in order to produce this result.  Under a fiduciary system the link between high powered money and the stock of money is not mechanical but political.

(Page 189).  The fundamental change made by the Federal reserve act of 1914 was to "furnish an elastic currency".  Hitherto high powered money had consisted of gold, national bank notes, subsidiary silver and minor coin, and an assemblage of assorted relics of earlier monetary episodes.  Henceforth, Federal reserve notes were available for use as hand to hand currency or as vault cash for banks….  Just as the exigencies of the Civil War had elevated one of the new forms of high powered money, the greenback, to a dominant place in the total, so world war one produced a correspondingly rapid growth the Federal reserve money.  By 1920, 69% of high powered money consisted of Federal reserve notes and deposits.

(Page 192.) The basic monetary problem seemed, to the founders of the Federal System, the banking crises produced by or resulting in an attempted shift by the public from deposits to currency.  Some means were required for converting deposits into currency without a reduction in the total of the two.  This required a currency that could be rapidly expanded -- to be provided by the Federal Reserve note--  and some means of enabling banks to convert their assets readily into currency—to be the role of discounting.

Since the commercial banks of that time held a large fraction of their assets in the form of "notes,  drafts, and bills of exchange arising out of actual commercial transactions" limiting the "lender of last resort" to rediscounting only such paper was not a serious liability….  Its imposition reflected a disapproval of "speculative" use as opposed to "commercial" activity, on one hand, and on the other a confusion between elasticity of one component of the money stock relative to the others, and the elasticity of the total.

Before the system began operations, world war one had begun.  Before long the belligerents had left the gold standard and a flood of gold started coming into the United States to pay for purchases by the Allies.  But the end of the war, the U.S. had placed an embargo on gold exports.

(Page 193.) Once the U.S. entered the war, loans on government security began to rival commercial paper as collateral for Reserve Bank rediscounts.  Conflicting monetary policies were sometimes pursued because it was not clear to the Federal reserve that rediscounting of any security, open market purchases, and gold inflows all had precisely the same effect on the money stock as the rediscounting of eligible paper.

(Page 212.) In it the opening years the Federal reserve system was essentially powerless to offset the monetary influence of the inflow of gold, in the terminology of the 20s, to "sterilize" the gold inflow.  It could expand the money stock but not contract it.

(Page 216.) After the U.S. entered the war on April 6, 1917, our allies no longer paid with gold, foreign held securities, or loans from private capital markets, but were financed by U.S. government credits to their accounts.  These Federal government deficits were soon added to by the expenditure to support U.S. forces.  These war deficits of $23,000,000,000 were financed by explicit borrowing and by money creation.

More comments by Fritz the Cat
`Sterilizing` gold is done when the Fed uses vault gold to buy something that does not qualify as secure enough to be held as collateral backing money.

Hopefully this brief expert into Friedman’s book for an elementary explanation of how fractional reserve banking, high powered money, and gold, can be used to create more money will make more assessable the argument I am about to make.

Evidence from the skeletal remains of our distant ancestors suggest that 30% of pre civilization deaths were the result of violence., Thomas Hobbes believes that such lives were "nasty, brutish, and short", in a "war of all against all".  Only fools despise civilization, but the war of all against all goes on with the difference being that a smaller percentage of the population suffered actual death or dismemberment, a drop in the standard of living being a more common fate for the losers.  The war of all against all is now more of an economic war.  Financial tools such as interest rate, gold holdings, credit ratings, inflation, deflation, and on and on now settle disputes formerly settled by clubs and spears.  Only Neanderthals would wish it different.

The too many people take the words of the Ahameds, Friedmans, and Shriers, the myth makers and storytellers of this world, that the economic reverses suffered, typically by the poor, are all the result of economic forces rather than the rules of the game; miscalculation rather than malevolent intent; or that governments are honest brokers.  When it is your ox being gored, you would be better off if you knew it was no accident.

I broke away from Ahamed’s book when France’s economy with nearly alone in prosperity, favored by its export economy, undervalued franc, rural population, and the thriftiness and adaptability of its citizens.  As if that thriftiness and adaptability were chosen rather than forced upon them.  Ahamed is writing for the investment and hedge fund crowd he serves, who would rather not face the events that led to their juicy returns on investment.

France sterilized its gold influx in the late 1930s because, according to Ahamed, she had been scarred by the currency crisis of 1924 and 1926.  Those inflationary crisis were implemented by a left government to the benefit of its constituents, farmers, workers, and industry.  The 1930s deflationary sterilization of gold repaid the left in kind to the advantage of the right’s constituents, banking and finance.  Both France and England were squeezing the workers of their countries to strengthen the bankers and rich.

As if it weren’t obvious I will point out the similarity to events in Europe today; with the Euro in place of gold preventing countries from devaluing their currency so as to make their exports more competitive, and with the wage cuts and decreased standard of living fattening up not their own rich, but the rich of other countries.  Now as then there is a general move to the political right, and a scape goating, then of the Jews, now of illegal immigrants.  Again there is an enemy, then Hitler, now Putin.  But back to our book.

(Page 384).  Blame for being the spark that brought the depression truly to America goes to a small New York bank, the United States bank (which had no government  connection), which went under in early 1931.  Run into the ground by shady management, the big bankers of the city refused to bail it out, as they had others.

(Page 389).  There were some 25,000 banks in the U.S. in the 1920s, and every year roughly 500 went under.  In the first nine months of 1930, 700 had closed their doors.  In October a drought in the Midwest and south had led 120 members banks of a southern chain to fail.  With these two failures Americans began slowly pulling their money out of banks, a trickle in the first few months, less than  1% of the total deposits.  But the high powered money multiplier effect also worked in reverse.  For every dollar withdrawn, a bank had to call $3 or $4 of loans in.  This led to further withdrawals to cover these loans, which led to further called loans.  In this climate banks began increasing their reserves, further limiting credit.  By the middle of 1931, bank credit had shrunk by almost $5billion, equivalent to 10% of outstanding loans and investments.

(Page 390).  By the summer people became more nervous, a bank failed in Chicago, and every bank save one failed in Toledo.  70% of that city’s deposits were frozen, and business came to a standstill.  The system was obviously in a crisis.  People were hoarding currency, banks were reluctant to loan, or were failing, prices were falling at 20% per year.  But the board in Washington was legally powerless to  initiate action and Federal reserve banks, who could have acted, refused to.  Many of the banks that were in trouble were not members of the Federal reserve system, only half of the 25,000 banks in the United State had joined the system, although they accounted for ¾ all deposits.

(Page 393).  In the spring of 1931 Germany had 4.7 million unemployed, 25% of the workforce, and another two million working part time.  A referendum organized by the right-wing German nationalist party to repudiate reparation payments gathered over four million signatures.  Hjalmar Schacht had broken with the government in December 1929 over a minor adjustment in the Young reparations plan.  After the October Wall Street crash he could see the coming crisis.  The strain of trying to satisfy competing interests had left him near collapse.  In January 1930 Schacht, as head of the Reichsbank, refused to sign an addendum to the Young plan giving the Allies full liberty of action in the event Germany defaulted.  In march he actually resigned.

(Page 399).  Three weeks later the socialist dominated government fell and a center right coalition, excluding socialist, took over.  The new chancellor, Heinrich Bruning, unable to get anything through the divided parliament, began to rule by decree.  After a defeat in the Reichstag he had President Von Hindenburg called for new election, two years early, in September 1930.  The NAZI party won 16.4 million votes, putting them into second place in the Reichstag.

(Page 400).  These results panicked the financial markets and half of Germany’s foreign reserves left the country.  To attract foreign currency the interest rate was raised to 5%, vs. 3% in London and 2% in New York and Paris.  With prices in Germany falling at 7% per year the effective credit rate was thus 12%, further exacerbating the economic weakness.  Bruning tried to balance the budget by lowering the state wages, and raising taxes, measures which made the Depression worse.  Bruning reduced the budget deficit to $100,000,000, less than 1% of GDP.  This while the U.S. ran a $2 billion deficit, 4% of GDP, and Britain ran a deficit of $600,000,000, 2.5% of GDP.

(Page 401).  Germany had borrowed so heavily during the boom times that they had exhausted their credit lines.  In addition, under the Dawes plan private lenders had payment priority in a time of crisis.  The young plan eliminated this proviso.  Schacht had tried to resist this revision to no avail, and private lending dried up.
(Page 403).  In January 1931 Schacht began meeting the Nazis.  On the fifth Goring got Schacht and Fritz Thysen, chairman of the giant United Steelworks, together with Hitler and Joseph Goebbels.  For 2 hours of Hitler did 95% of the talking.

(Page 404).  The failure of Credit Anstalt, the largest and oldest  Austrian bank, owned by the Rothschilds, on Friday May8,1931, began the depression.  A rescue package announced on Monday the 11 th was too small to stem the tide of withdrawals, not only from the Credit Anstalt, but for all Austria’s banks, which lost $50,000,000 in deposits in four days, about 10% of the nation’s total.  The Austrian National Bank injected 50,000,000 into the nation’s money supply, raising it by 20% overnight.  A coalition of International Bankers took three weeks to raise a mere $15,000,000 rescue fund.  People began trading money in for gold.  The French government’s secretly encouraged French banks to pull money out of Austria.

(Page 407).  In many minds Austria and Germany were linked, so the banking crisis spread to Germany.  Thomas Lamont, a senior partner at JP Morgan and co, feared that Germany would impose exchange controls.  With American institutions holding about $1,000,000,000 in short term loans to Germany, such a move could threaten the solvency of more than one U.S. bank.  Lamont suggested to  U.S. president Hoover that the U.S. should unilaterally suspend war reparation payments.

(Page 410).  During the first three weeks of june Germany lost some $350,000,000, nearly half its gold reserves.  The population was in increasingly dire straits.  That year, when the Reichswier needed 6000 new recruits, 80,000 men applied, half of them malnourished.  NAZI and communist agitators were drawing a larger crowds.  The banking crisis had spilled over into Hungry, Romania, Poland, and Spain.

Hoover’s reparations suspension was publicly announced on June 20.  It came with a catch: the U.S. would suspend $385,000,000 in debt payments from Britain, France, and Italy, only if those countries would suspend an equal amount of German war debt.  It’s seems Hoover had gathered support from every place except, inexplicably, the one place with most needed, France.  France had Europe’s biggest army, gold reserves, and war debt from Germany.  France predictably exploded in anger.

While the American ambassador to France, Walter Edge, and Andrew Mellon, secretary of the treasury who had been pulled from a private vacation, try to bring the French around, German gold reserves continued to hemorrhage.  The central bankers provided a $100,000,000 loan on June 24.  It was gone 10 days later.

(Page 414).  Hans Luther, who had succeeded Schacht, was faced with a dilemma on July 8.  If Germany tried to bail out the failed Danatbank, Germany would fall below the minimum a reserve threshold it was required by law to hold, provoking a run on the currency.  If it didn’t it risked a run on all German banks.  Luther called, then flew to London to meet Morgan Montegue.  Norman decided that Germany was now irretrievable.  Germany’s GDP of $13,000,000,000 was shrinking by the month, it had a reparation debt of nine billion dollars and a foreign private debt of the $6,000,000,000, $3.5 billion of which would short term and could be pulled at any minute.  Over the last year $500,000,000 had left the country.  Barely $250,000,000 in gold reserves remained.  Germany’s only hope was a long-term loan from France.

(Page 416).  France imposed onerous terms for a $300,000,000 loan.  The next day the German cabinet rejected them.  America rejected further loans, insisting it would be throwing good money after bad.  The next day of the BIS announced that it would not advance any money.  The day before, Monday, July 13, 1931 the Danatbank failed to open its doors.  It had lost $240,000,000 in deposits, some 40%, over the last three months.  Long lines formed at the rest of Germany bank, and that night President Hindenburg declared a bank holiday.  They remain closed for two weeks, and the commercial life in Germany came to a virtual standstill.

(Page 420).  The collapse of the banking system sent the economy into a tailspin.  Over the next six months production fell by another 20%.  Production was 60% of its 1928 level.  Nearly 6 million men were unemployed, a third of the labor force.

In October 1931 the party of the right staged a collective rally of everyone who was, or ever had been against democracy.  The star of the show was Hitler, but Schacht also spoke, declaring the country bankrupt, and thus enraging the Reichstag.  That most of the debt had been amassed on Schacht’s watch added to the anger.  Now he had enraged the democratic center.  Only the Nazis were left.

(Page 422).  On July 14 Norman return from the BIS meeting in Basel to find the crisis spreading to Britain.  A Lazards investment houses "rogue trader" had placed a large bet on the collapse of the French franc and lost $30,000,000, double the bank of capital.  It was bailed out by the bank of England, but when two other British merchant banks requested bailouts next week, Norman could only arrange  commercial loans for them.  The financial crisis spread through eastern Europe into Egypt and Turkey.  Bolivia had defaulted in January, and Peru in march.  Chile and Mexico faced bankruptcy.

(Page 423).  During Britain’s heyday as a financial center, British industry and British finance had complemented each other.  Her large export surpluses financed her long-term global investments.  After world war one and Britain’s return to the gold standard with an over-valued pound sterling, industry became a drain on government finance.  Banking, determined to maintain its position, continued to make $500,000,000 in long-term loans each year, financing them with short-term borrowing.

At this time a gov’t report detailing the extent of this practice became public.  This "Macmillan report"  revealed that the City’s short-term liability to foreigners amounted to three billion dollars.  Moreover, Britain had $50,000,000 in the now frozen German accounts, and several 100,000,000 dollars in Central Europe and Latin America.  Investors started withdrawing funds from the City.  In the last two weeks of July the bank of England lost $250,000,000, almost half its gold reserves.  Norman raised the interest rate from 2.5% to 4.5% in hope of retaining capital.  He borrowed $250,000,000 from the New York Fed and Bank de France.  10 weeks of steady crises finally led to Norman’s nervous collapse on July 29.  On August 15 the sailed for Canada, under doctor’s orders, to recuperate.

On July 30 another government report, the May committee, became public.  The government was running a $600,000,000 deficit, 2.5% of GDP.  The Mae committee suggested cutting expenditure by $500,000,000, including a 20% cut in unemployment benefits, and raise taxes by $100,000,000.  This was financial orthodoxy at the time, but Maynard Keynes labeled it "foolish".  That drain of gold continued, and Britain was finally forced to seek a loan from JP Morgan, who stipulated $350,000,000 in budget cuts, including a 10% cut in the Dole, and $300,000,000 in tax increases.

(Page 427).  When the terms of the loan were announced the cabinet on August 22, it split over the cuts in unemployment benefits.  That evening prime Minister Ramsey Macdonald tendered his government’s resignation.  Labor party adherents were convinced that Wall Street banker the opposed to socialism had manipulated a market to undermine their party.  The new government, with MacDonald still at its head, was composed of the united Conservative Party, with fragments of Labor and Liberals.

(Page 428).  By now was obvious to most observers that Britain would soon leave the gold standard, and that the budget deficit had little to do with it.  But he had borrowed at 3% to loan at 6%, ordinarily good business, but making risky loans in an effort to keep the game going was to be her down fall.  Britain’s financial sector would have to accept the blow to its prestige that going off gold implied.  Perhaps later it could reenter gold, with the pound at a lower exchange rate, making Britain’s exports competitive again to provide a base for her financial system.

By the middle of September the bank was losing $25,000,000 a day.  On September 17 and 18 th it lost $80,000,000.  Since the crisis began Britain had lost one billion dollars in gold.  That week end Britain suspended gold payments, Keynes was ecstatic.  European Bankers thought it and utterly dishonorable step, inflicting heavy losses on those who had trusted her word.  Within a few days the pound fell by 25%.  By December it was down 30%.

(Page 432).  During the next few months 25 countries followed Britain off the gold standard.  To the average Britisher, after a few days of confusion, it was as if nothing had happened.  While prices in the rest of the world continued falling, dropping 10% of the next year, in Britain deflation came to an end.  Prices rose 2% in the next year allowing manufacturing to revive and put people back to work.

The central bankers who had been convinced to hold British pounds lost heavily.  The Banque De France, far from seeking to undermine the pound, as urban myth held, had retained all $350,000,000 of it sterling deposits and lost $125,000,000.

(Page 434).  Europeans, especially its central bankers, became alarmed lest the U.S. follow Britain’s lead, and over the next five weeks converted 750,000,000 paper dollars into gold.  Alarm swept through the already fragile banking system, and in the month after Britain went off gold 522 American Banks went under, by the end of the year a total of 2,294, one out of every 10 banks, with $170,000,000,000 in deposits, would suspend operations.

(Page 436).  The Federal Reserve had begun 1931 with $4.7 billion in gold reserves.  Even after the $750,000,000 outflow it was in no danger of being stripped bare, as Britain and Germany had been.  Nevertheless, the Fed’s regulations stipulated that 40% of every Federal reserve note be backed by gold, with the remaining backed by so-called eligible paper, prime commercial paper used to finance trade.  Though the Fed held government securities, which it bought and sold in order to withdraw money from the economy or injected it into it, (it’s open market operations), it was not allowed to use government bonds to back the currency, lest it use government bonds to back government money to finance  deficit spending and end up with hyperinflation as had Germany in the twenties.  But with the depression and deflation, good quality commercial paper was hard to come by, and gold was beginning to be squeezed.  

The government was beginning to run low on money to bail out the banks that needed it.  President Hoover tried to convince the big banks to bail out the small ones, but after a $100,000,000 experiment the big banks dropped out, fearing the problem was big enough to swallow them as well.  Thus the solutions which were rational for individuals, (withdrawing deposits and holding cash), and individual banks,( refusing to bail out the weaker ones), were drawing the system as a whole into a downward spiral.  As noted earlier, the fractional reserve system permitting an elastic supply of money required that, just as every dollar in deposits could be converted into $3 or $4 of new credit, every dollar withdrawn from deposits required their withdrawal of 3 to 4 dollars of old credit, i.e. loans had to be called in, thus forcing liquidation of assets held as security into a depressed market, further depressing the market, Et cetera.  Deflationary psychology had set in: fearing, or hoping, that prices would fall further, people held off consuming and investing, which was exactly what the system needed to recover.

(Page 438).  1932 was the deepest year of the depression in the United States.  Between September 1931 and June 1932 production fell 25%, investments fell 50%, and prices dropped another 10%.  Unemployment passed 20%.  American corporations, which had made almost $10 billion in profits in 1929, collectively lost three billion dollars in 1932.  The Dow, which had peaked at 381 on September 3, 1929, and was trading around 150 before the European currency crisis, hit a low of 41 on July 8, 1932, a drop of almost 90% over the 2 ½ years since the bubble first burst.  John Maynard Keynes compared the depression to the dark ages, which had lasted 400 years.

In January 1932 Federal reserve board Chairman Eugene Meyer persuaded the administration to establish the reconstruction finance corporation to channel public money, a total of $1.5 billion, into the banking system.  In February 1932 he persuaded Congress to pass legislation making government securities eligible to back currency, allowing the fed to inject one billion dollars of new currency into the banking system.  The two measures together finally provided enough money to deal with the problem.  It was not too little, but it was too late.  The deflationary psychology had grabbed hold over the past two years and the economy, the business cycle writ large, was now in the grips of fear, and rational remedies were insufficient.  People were afraid to borrow and banks were afraid to lend.  The money ended up as bank reserves.  Total bank credit continued to shrink at 20% per year.

1932 was in an election year, and the Democratic candidate, Franklin Roosevelt, the jaunty and optimistic governor of New York, faced the dour and resentful president ,Herbert Hoover.  Roosevelt’s proposed solutions were self contradictory, but he won with the largest majority and nearly 100 years.

The period between the election and the inauguration saw a new wave of bank failures, the worst centered on the guardian trust company of Detroit.  Controlled by the scion of the Ford Motor Company, Edsel, the bank ran into problems when the market for cars dried up.  The gov’t refused to bail the bank out unless the Fords, second richest family in the United States after the Rockefellers, increased its stake in the bank, which the patriarch, Henry Ford, 70 years old and increasingly autocratic, refused to do.  On February 14 the governor of Michigan closed all 550 banks in the state for eight days.  Indiana closed its banks on the 23 rd, Maryland on the 25 th, and Ohio on the 28 th.  In March Kentucky and Pennsylvania close their banks.  During February and the first few days of March close to two billion dollars had been withdrawn from banks, 1/3 all the currency in the country.  The fear of the U.S. leaving the gold standard lead to an international run on the dollar.

(Page 443).  Suspicions over Roosevelt’s plan further weaken the dollar.  As we saw earlier, a shortage of gold in a country on the gold standard requires a drop in the price of commodities when the demand for gold goes up.  Similarly, the flow of gold out of a country requires a raise in interest rates to keep money at home.  Both these tendencies work against the farmer, a significant democratic voting bloc.  On January 31, the secretary of agriculture designate Henry Wallace, the closest thing the United States had to a socialist, was quoted as saying that "England has played us for a bunch of suckers.  The smart thing to do would be to go off the gold standard a little further than England has.  The British debtor paid off his debts 50% easier than the United States debtor has’.  There were six bills in Congress involving the emergency issue of currency or a change in the value of the dollar.

The banking establishment viewed the incoming president’s policies with distrust.  What they wanted was Hoover’s program-  a balanced budget with no inflation or devaluation.  The New Deal however, required inflation and a budget deficit.

In the last two weeks of February the New York fed came under pressure, losing $250,000,000 in gold, almost ¼ its gold reserves.  There was plenty of gold in the system as a whole, but the regional reserve banks were in trouble as well, and may have refused loans to the more liberal New York Fed.  Had the New York fed and run out of gold reserves and had to start calling in loans the collapse of the market could have brought the whole Federal reserve system down.

(Page 445).  Both George Harrison, head of the New York fed, and Eugene Meyer, chairman of the Federal reserve board, pressured president Hoover to proclaim a bank holiday, but Hoover preferred to let the new president take that step.  On Thursday, March 2, two days before the new president was to be inaugurated,Harrison called Meyer to inform him that the New York fed had fallen below its minimum gold reserve ratio.

On Friday, March 3, the New York Fred lost a total of $350,000,000,$200,000,000 in wire transfers out of the country and  $150,000,000 in actual physical withdrawal by banks in the New York area.  It tried to borrow from the Chicago reserve but was turned down.  That night, with neither a Hoover or Roosevelt willing to act, the Federal reserve board began contacting the state governors, and in the middle of the night New York Governor Herbert Lehmann of the Lehmann banking family declared a bank holiday.

(Page 448).  In three years commercial bank credit had shrunk from $50,000,000,000 to $30,000,000,000 and ¼ of the country’s banks had collapsed.  House prices were down by 30%, half the mortgages were in default.  Industrial production had fallen by half, from $100,000,000,000 to $55,000,000,000.  A quarter of the workforce was unemployed.

Editors comments.

The end of September, 2014 saw a substantial fall in stock markets around the world.  In addition to the ongoing crisis in Ukraine, a new crisis that popped up in Hong Kong with hundreds of thousands of protesters occupying the city center in protest of the communist party’s reneging on democratization  promises.
And in Europe Mario Draghi’s  promise to do "whatever it takes"  to rescue the European Union was dealt a harsh blow when Germany’s high court declared that it would be unconstitutional for Germany to contribute to Draghi’s "big bazooka" bond buying plan modeled on the U.S.’s  "quantitative easing".

In the U.S. quantitative easing, as I understand it, took the form of the government buying initially $80,000,000,000 a month of U.S. bank’s assets (loans).  At one point they were explicitly buying home mortgages, presumably the securitize sub-prime mortgages whose increasing default level had initiated the crash of 2007.  This money, supposedly intended to revive the general economy, instead found its way into the Wall Street speculative economy just as happened in the run-up to the October 1929 crash.  In the 1929 crashed the professionals were already out, and the amateurs absorbed the loss.  Those who don’t learn from history are doomed to repeat it.

I have recently had a minor a-ha moment with the realization that the TARP and QE exercises around the world are designed, not to stimulate the economy, but to put a floor under the banking system’s losses.  As explained earlier, the fractional reserve banking system, allowing for an elastic money supply, permits the private sector to participate in the creation of the nation’s money supply by making loans backed up by the bank’s assets, i.e. other loans, plus vault currency and gold.

If the value of these assets falls sufficiently to bring the bank’s reserve below the Federal Deposit Insurance Corporation’s (FDIC) minimal mandated level, the bank must sell these assets or call in the loan, both of which have the effect of further depressing an already depressed market.  The system allows the creation of several new dollars for every dollar held in reserve, but also call for the destruction of several dollars for every one taken out of reserve as happens when stocks and bonds held as bank reserves lose value on the stock or bond market.  By buying the stocks or bonds at above market value the government prevents the snow balling  effect a falling stock market can have.

This raises a few questions in my mind.  How are the stocks and bonds of these QE purchases chosen?  Crony capitalism and state capitalism loom large here, as when General Electric purchased a large portion of (a year’s production of) Volt electric cars that the Obama administration was pushing, both because the U.S. gov’t now held a substantial (20%?) share of General Motors stock as part of its bailout program, and as part of his support of the banking industry’s struggle with petroleum’s tax-writing dominance, as explained in the dark side one.

(Page 451).  On FDR’s first day in office he closed all U.S. banks for four days.  He also prohibited the export or private holding of gold.  When the first bank opened on Monday March 13 th, people began depositing the money they had just withdraw.  Bank deposits under the new emergency banking act would be guaranteed by the government.  Among the raft of New Deal laws passed was a last minute addition, the temporary abandonment of the gold standard and the devaluation of the dollar.

(Page 461).  Roosevelt, against the advice of all his economic advisers, reasoned that because the creation of credit was regulated by the amount of gold held in reserve, one way to increase the amount of credit would be to increase the value of gold by decreasing the value of the dollar the gold was priced in.  Roosevelt now had the authority to devalue the dollar against gold by up to 50% and to issue three billion dollars in greenbacks without gold backing.  A government determined it to drive prices higher broke the psychology of deflation.  During the following three months wholesale prices jumped by 45% and stock prices doubled.  With prices rising the real cost of borrowing money dropped.  New orders for heavy machinery rose by 100%, auto sales doubled, and industrial production rose by 50%.

(Page 465).  In Britain the pound sterling had fallen 30% since going off gold.  In 1932 prices had risen 2% while the rest of the world’s prices fell by 10%.  Going off gold had allowed Norman to lower interest rates to 2%.  The combination of the end to deflation, cheap money at home, and a lower pound abroad, making British goods more competitive in the world market, touched off an economic revival.  Britain was the first major economy to lift itself out of the depression.

(Page 470).  France had avoided the collapse of the world economy in 1929 and 1930 because its undervalued franc had made its exports cheap in the world market.  Now with Britain and the U.S. off gold the roles were reversed.  What France wanted now was currency stabilization, a floor below which the pound and a dollar would not be allowed to drop.  Roosevelt made it plain that he was primarily focused on an economic recovery in the U.S., and international considerations were secondary.

(Page 471).  By October 1933 commodity prices had begun to fall again.  Roosevelt, again against the advice of nearly all his advisers, began buying gold on the open market, presumably with newly printed money.  Slowly the government pushed the price of gold up.  When it reached $35.00 an ounce the president agreed to fix it there.  The dollar had been devalued by 40%.

(Page 474).  Prices again began moving up, by roughly 10% per year.  Once prices began to rise the burden of interest payments and the real cost of money were automatically reduced, making business more willing to borrow and consumers more ready to spend.  In the four years after 1933 the value of gold held by the fed almost tripled, to $12,000,000,000, in part due to the increased value of the gold and in part due to the increased mining prompted by its increased price.  In Roosevelt’s first term U.S. industrial production doubled and the GDP expanded by 40%.

(Page 475).  In 1935 Congress passed a banking act designed to reform the Federal reserve.  Authority for all major decisions was now centralized in a restructured board of governors.  The regional reserve banks were stripped of much of their power, and responsibility for open market operations was now vested in a new committee of 12, comprising the seven governors and a rotating group of five regional bank heads, renamed presidents.  The secretary of the treasury and the comptroller of the currency were removed from the board, giving it theoretically even greater independence from the administration.  In March 1934, Marriner Eccles took over as head of the Federal reserve board, and with unemployment still high and confidence still weak, he decided that the feds first task should be to keep interest rates as low as possible.

(Page 478).  The U.S. and Britain started pulling out of the depression shortly after leaving the gold standard.  Germany, after it ran out of credit and gold in the summer of 1931, continued to act as if it were on gold, still terrified of the hyperinflation of 1923.  This deflationary stance created yet more unemployment and pushed the country farther to the right.  In May 1932 the right-wing cabal forced Bruning out of office.  The following month Britain and France formally agreed to forgive reparations.  In August Bruning’s replacement, Franz von Papen, called new elections.  The Nazis won 230 seats, doubled their previous representation, making them the largest party in the Reichstag.  Yet President Von Hindenburg was still not ready to invite Hitler to form a government.

(Page 480).  Over the next few months Nazis undermined successive governments in the Reichstag.  Schacht became a prominent supporter and fundraiser for the party.  In November 24 industrialists, including Schacht, steel magnate Fritz Thyssen, and arms manufacturer Gustav Krupt, signed an open letter to Von Hindenburg urging him to appoint Hitler chancellor, which he finally did in January 1933.  Schacht was back in the Reichsbank two months later, charged to fight unemployment and to find the money to rearm.  In August 1934 Schacht became minister of the economy.

(Page 481).  Immediately on taking office Schacht threw orthodox economics overboard.  He embraced a massive program of public works financed by borrowing from the central bank and printing money.  Over the next few years unemployment fell from six million at the end of 1932 to 1.5 million four years later.  Industrial production doubled over the same period, but much of the increase came in arms related industries, with consumer product production stagnating.

(Page 482).  Schacht refused to devalue the mark, all of Germany was forced into an autarkic economy connected to Eastern Europe and the Balkans, with barter replacing money exchange, and with shortages and rationing the rule of the day.  By the late thirties he came into conflict with NAZI leaders over corruption, Though not above anti-Semitic remarks, he fought against the more extreme anti Jewish policies, although on pragmatic economic grounds.

(Page 484).  Schacht was removed from office in November 1937, after trying to push Hitler to go slow on the arms buildup.  In the years before the war he was part of several conspiracies by conservative politicians and businessmen to overthrow Hitler by convincing the army high command that Hitler was leading Germany into a war it wasn’t ready for.

(Page 485).  After the war Schacht was one of the 24 major figure to be prosecuted at Nuremberg.  He insisted that he only acted in self defense to protect Germany against the Allied economic strangle hold, and asked the court to imagine what a cultured people like the Germans would have to be put through before they would adopt a demagogue like Hitler.  He was acquitted, but rearrested by the state of Bavaria.  After five different trials, all ending without a conviction, he was finally released in 1950.  He died in 1970 at the age of 93.  

(Page 489).  John Maynard Keynes early on had called for many of the policies the world eventually adopted, going off the gold standard, cancellation of German reparations and French and British war debts, and a central bank policy of cheap credit.  While these policies were still in limbo he began  studying the cause of mass unemployment and why conventional remedies such as cuts in interest rates did not work to lower unemployment.  The result was published in February 1936 as "the general theory of employment, interest, and money" which is still used as a foundation for much of the government and central bank’s management of the system.

(Page 491).  Keynes became a rich by speculating, and was part of the British establishment during WWII.  After the war he proposed creating an International Financial System based, like the gold standard, on rules, while tempering its rigidity.  Currencies were to be adjustable if the economic circumstances changed.  No longer would countries be forced to raise interest rates and create mass unemployment to protect the currency’s value.  The second part of the plan was an international central bank which would loan money to countries in need.

(Page 492).  The Americans were working on a similar plan under the direction of Henry Dexter White, the assistant secretary for international affairs at the U.S. treasury.  He was also, if not a Soviet agent, at least a fellow traveler, passing along secrets about a whole range of U.S. financial policies to Soviet intelligence.
(Page 494).  Over the next two years Keynes and White worked out their differences regarding the new institution, with Britain doing most of the compromising.  By 1944 they invited 44 countries to Bretton Woods, New Hampshire to discuss restructuring the world international monetary system, to be called the International Monetary Fund.  The main focus of the meeting was on how much money each country would be allowed to borrow.  The IMF provided the foundation for the reconstruction of Europe and Japan after the war, and set the stage for one of the longest periods of sustained economic growth the world has ever seen.

(Page 497).  In the epilog Ahamed make the claim that the great depression of the thirties was not one but a series of crisis, each one feeding on the one before: the contraction of the German economy that began in 1928, the Wall Street crash of 1929, the bank runs in the the end of 1930, the unraveling of European finances in the summer of 1931.  Then he said what a lot of other people have been saying recently, that each of these episodes has an analog in the contemporary crisis.

(Page 498).  The first shock, the sudden halt in the flow of American Capital to Europe in 1928 which tipped Germany into recession has its the counterpart in the Mexican peso crisis of 1994.  During the early 1990s, Mexico, like Germany in the 20s, borrowed too much short term money.  When the U.S. interest rates rose sharply in 1994, Mexico, like Germany in 1929, found it progressively harder to roll over its loans and was confronted with a similar choice between deflation or default.  But, says Ahamed, the U.S. rapidly gave Mexico an emergency $50,000,000,000 loan, and Mexico devalued its peso.  If only the world had acted differently back then….

The next crisis was the great crash of 29, which had a counterpart in the fall of the stock market in 2000.  He blames both a rogue’s gallery of Wall Streeters and corporate insiders.  Both were followed by  significant cuts in interest rates.

The next crisis was a loss in faith in the banking system, in 1930 and1931 it was the national banking systems that are now guaranteed by the government.  In the crisis following the 2007 market crash it is the bankers and investors who are pulling their money out of financial institutions of all stripes, not only commercial but investment banks, money market fund, hedge fund, etc.  Every financial institution that depends on wholesale funding from its peers has been threatened to a greater or lesser degree.

(Page 500).  In 1930 and 1931 the fed watched thousands of banks fail.  Now central banks in treasuries around the world have injected titanic amounts of liquidity into the credit markets and provided capital to banks.

Finally, the European Financial crisis of 1931 had its modern day counterpart in the emerging market crisis of 1997 to 1998. South Korea, Thailand, and Indonesia all had to suspend payments on hundreds of billions of dollars of debt.  Asian currency collapsed against the dollar eventually setting off the default of Russia in 1998 and Argentina two years later.

(Page 501).   Ahamed sees the great depression as a series of blunders by financial officials that allowed crises to pile on top of crises and snowball, whereas the current series of crises had been managed, in large measure by learning from the mistakes of the past, so as to stretch the crisis out over more than a decade and so at least partially ameliorate each crises before the next struck.

Ahamed sees two primary miscalculations that led to the great depression.  The first was trying to collect all the debts arising from world war one.  The second was taking the world back onto the gold standard, itself a mistake, confounded by the misaligned rates the countries chose to impose on themselves.  The central bankers held the system together as long as possible by making loans to Germany more palatable by the low interest rates in the U.S..

(Page 502).  The low interest rates also tempted people into wall street, feeding a bubble that had to pop some time.  When domestic considerations finally led the fed to raise interest rates high enough to temper Wall Street speculation, the Germans were priced out of the loan market and defaulted on war reparations, leading to a wave of other collapses.  The shock of which caused the wall street collapse of 1929.

(Page 504).  The final paragraph lays the blame for the great depression on a lack of understanding as to how a world economy operated, and praises John Maynard Keynes for bringing light into that realm and "armed with his insights, the world has avoided an economic catastrophe such as over took it from 1929 to 1933".  

Editors comments
Haljmar Schacht thought that the main economic problem after the war would be the tremendous debt overhang  which would lead to a general European bankruptcy.  Ahamed is not of that school.  He prefers to pretend that the great depression of the thirties was due to the primitive state of economic theory then current, a condition alleviated by John Maynard Keynes, whose advise, if taken in time, would have ameliorated or even prevented the great depression.  He gives as evidence of the fact that the world has not entered into a similar depression since the world began paying attention to Keynesian principles.

Fritz the cat is not of that school, but is aligned with the Schachtian school of debt overhang, a school adumbrated by another brilliant and totally ignored economist of that period, Irving Fisher.  Fisher,  a professor of economics at Yale university, wrote "the debt deflation theory of great depressions", published in October 1933, that was, and is, largely ignored by the New York/ District of Columbia nexus that pipes the tune that we all dance to and pay for.  A brief summary of that book is given  as appendix A.

As part of my argument with Ahamed, I will adduce the "consider the source’ factor.  As mentioned earlier, Ahamed is deeply entwined in the New York/ DC nexus of borrow and spend, a symbiotic relationship that is parasitical on much of the rest of the world.  He could hardly be expected to kill his golden goose by pointing out that it is the creditor/debtor relationship, both the boon and bane of capitalism, that is at the root of depressions and war, as was argued in the Dark Side Two.

The Ahamedian proclamation of Keynesian victory over depression was answered by Schacht (page 336)  when he broke with the Weimar government policies: continued borrowing will only postpone, and indeed make worse, the inevitable day of reckoning.  Ahmed declared victory in 2009 and went back to promoting the borrowing and spending that have only postponed a day of reckoning.  That is his business, after all.

Keynes proclaims, with obvious satisfaction (page114) the "disappearance of the social order we have known", and the "abolition of the rich".  Large landholders without title of nobility had largely comprised the officer core of both Britain and Germany, and suffered disproportionate losses in the trench warfare of world war one, and were replaced in government by the popularly elected middle class bourgeoisie that Keynes identified with and spoke for, but the rich, like the poor, will always be with us.

Illustrative of this Keynesian thinking was the Dawes plan for German reparations of April 1924.  (Page 205-215).  Predictably it started with a loan from America to Germany, who used the money to pay reparations to Britain and France, who used the money to repay war debts to the United States government.  Fritz the Cat suspects that in each of these political/banker nexuses the money passed through took a cut, ensuring the game’s continuance.

On paper the Keynesian model is intended to dampen down the business cycle by removing money from the system through taxation of the rich on the cycle’s upswing, and then stimulate the economy by transfer payments to the poor (unemployment and disability benefits), during the cycle’s downswing.  Predictably the taxation of the rich get short shrift, while the redistribution side goes on as planned, even if, or especially if, it is not the neediest who receive the money, necessitating loans to finance redistribution, gladly made by the bankers and gladly spent by the politicians, once again showing the symbiotic relationship, this time parasitic on the taxpayer.

The Keynesian remedy currently  (October 2014) being practiced by Washington, first the TARP program initiated by Bush junior in the final days of his presidency, continued under Obama and merged into the "quantitative easing" program, is slowly being tapered off and is scheduled to end soon.  As in the months leading up to the September 1929 crashed, Fritz the Cat assumed that all the professionals are already out of the stock market, leaving the middle class amateurs holding the bag when it finally crashes.

When that happens a wave of selling into a depressed market will bring the stock market crash home to the rest of the economy, as businesses fail, cut back production, and lay off workers, as happened in the U.S. in the early thirties.  The extreme tension that probably lead to Strong’s early death, Norman’s nervous collapse, and Schacht’s move to the political far right must be felt in the world central banks today.  The $80,000,000,000 the Federal Reserve has been borrowing or printing and shoving into the economy every month has largely found its way to Wall Street, there being so few other places to invest money profitably.
When the speculative bubble is inflating, "a rising tide raises all boats", that is, all stocks, good and bad, increase in value, contravening the market’s intended role of the rational allocation of money to productive purposes.  Another facet of Keynesian economics, low interest rates, not only inflates this bubble, but also drives money overseas to higher interest rates, so-called "hot money" of short-term investments that can be pulled out of a country on short notice.

Just as money flowed into Germany between 1924 and 1928, then left for the higher rate of return at home on "brokers loans" in New York City, driving Germany into recession and enabling NAZI rhetoric to triumph at the polls, so the hot money leaving the Asian tigers in the mid nineties, eventually resulting in the default of Russia and Argentina, and the hot money leaving the BRICs over the past five years, have driven those country’s social division and fed radical solutions.  Sanctions against Russian now prevent any loans longer than 90 days, ensuring that all the money it is forced to borrow after its hard currency reserves run out is hot money.

Russia today is not the Russia of world war two.  Then the myth of communism’s inevitable triumph and the reality of totalitarian oppression still held the masses of Russia in it’s terrible grip, ensuring the defense of Moscow and Stalingrad and the defeat of Hitler.  Now, after glasnost and perestroika, after the collapse of the iron curtain, after the west re-absorbed much of Eastern Europe that Russia had overrun in the final months of world war two, after having as many of the middle class Russians who could, leave, after the wave of crony capitalism allowed communist party big shots and expatriate Russians to buy up the carcass of Mother Russia on the cheap, after the communists had their way with Mother Russia for 70 years, after alcoholism, AIDS, and drug addiction have ravaged the countryside, after most of her light arms have gone into the black market and most of her atom bombs were sold to the United States, and the rest are ageing and in doubtful  condition, will the Russian people still freeze to death or starve to death before deserting their position?  Could a wave of stealth bombers and drone aircraft and cyber warfare on ballistic missile sites shock and awe Moscow into submission?

Way back in the Dark Side One Fritz the Cat predicted a rapid recovery of the U.S. economy after the petroleum industry had unleashed fracking revolution and thus beaten back the Wall Street assault on its tax-writing privileges.  He now feels, after six months of staring into the abyss, that he was overlooking the international, imperialistic dimension of the equation.  As soon as the world recovery begins, the price of oil will start going up, a strengthening the very countries that the New World Order intends to return to the western fold:  Venezuela, Iran, and Russia.

The price of oil fell below $90.00 a barrel on October 10, 2014, approaching the level where both Russian oil and fracking are unprofitable.  Russia desperately needs to modernize its oil fields, yet is prevented by western sanctions from obtaining the technology only the West has, and borrowing the long-term money it needs.  Its rapprochement with China is a chimera, dependent on the construction of an immensely long and expensive pipeline.  The Chinese are hard bargainers, and anyway have   problems of their own:  they are dependent on the west to buy the goods they make and assemble.

As I argued in the Dark Side Two, the US’s latest addition to its arsenal is consumer power, the ability to turn world prosperity off and on like a spigot .  It is currently turned off and will not be turned back on until Putin’s goose is well on its way to being cooked.

The recent strengthening of the dollar is good news for us expatriates.  Maybe we can buy up some of the world prime real estate at bottom dollar, has happened in France and mid 20s.  Since the days of globalization the third world countries have been devaluing their currencies, hoping to export their way to prosperity.  Japan, the first export economy to operate under IMF auspices, began some three years ago with the so called Abenomics, Japan’s version of "quantitative easing", also known as "monetizing the debt". The Japanese, and Asians in general have some of the highest rates of savings in the world.  The elderly made and saved a lot of money while Japan Inc. was still an exporting powerhouse.  Those who came of age after Japan had lost her export dominance,  first to the Asian tigers and then to the BRICs, felt somewhat left out and voted Abe in as premier.  QE induced inflation will hurt the elderly savers but should stimulate the Japanese economy and give the young a chance at meaningful employment.

Recall that a currency that is undervalued comparison to its trading partners is able to produce cheaper goods, boost industry and employment, and that a weak or undervalued currency usually results in or is a product of inflation, which brings increase prices.  Increasing prices are incentives to produce now and sell  later at a higher price, and to buy material and equipment before it raises in prize, thus stimulating the economy.  A weak currency is not good for the financial sector because in an inflationary environment the money that is repaid will purchase less than when it was loaned out.

Appendix A:      the debt deflation theory of great depression´       Irving Fisher      1933  Thai Sunset Publications     Thailand

(Page six)     Introduction by an anonymous London banker:  Professor Fisher made his "permanently high plateau" remark (in Sept., 1939) in an environment very similar to the one prevailing in the summer of 2007.  Currencies had been competitively devalued in all the major nations as they sought to gain or defend market share.  The devaluations stoked the asset bubble and easy credit led to more and more speculative investments, including a boom in globalization as investors bought bonds from abroad to gain higher yields.

(Page seven).  In the great booms and depressions, each of the above named factors:  (over or under production, consumption, spending, savings, investment) has played a subordinate role as compared with the two dominant factors, namely, over indebtedness to start with and deflation following soon after.

Fisher outlined how just nine factors interacting with one another under conditions of debt and deflation create the mechanisms of boom to bust for a great depression:  assuming that at some point in time, a state of over indebtedness exists, this will lead to liquidation, through the alarm of either debtors or creditors or both.  Then we may deduce the following chain of consequences in nine links: number one.  Debt liquidation leads to distress selling and,  number two.  Contraction of deposit currency, as bank loans are paid off, and to a slowing down of the velocity of circulation.  This contraction of deposits and their velocity, precipitated by distress selling, causes a strengthening of the dollar.  Assuming that this fall in prices is not interfered with by reflation  or otherwise, there must be.  number four.  A still  greater fall in the net worth of businesses, precipitating bankruptcies and number five.  A like fall in profits, which in a "capitalistic", that is private profit society, leads the concerns which are running at a loss to.  Number six, a reduction in output, in trade and in employment of labor.  These losses, bankruptcies, and unemployment lead to number seven.  Hording and slowing down still more of the velocity of circulation.  The above eight changes cause number nine.  Complicated disturbances in the rates of interest, in particular, a fall in the nominal, or money, rate and a rise in the real, or commodity rate of interest.

(Page 10).  Had Fisher observed the Greenspan /Bernanke Fed in action, he might have updated his theory with a revision.  At some point capital betrayed into unproductive works has to be either repaid or written off.  If either is inhibited by reflation or regulatory forbearance, then a cost is imposed on productive works, whether through inflation, higher interest, diversion of consumption, or taxation to socialize losses.  Over time that cost ultimately hollows out the real productive economy, leaving only bubble assets standing.  Without a productive foundation, as reflation and forbearance reach their limits, those bubble assets must deflate.

All the above is from the introduction.
(Page 24).  In the lead-up to a depression we can often see mild gloom and a shock to confidence leading to debt liquidation, as people decrease unnecessary consumption and pay off  loans taken in boom times, which expanded consumption and production.  The fall in consumption leads to decreased profits and distress selling.  People with money to invest put it into safe loans (i.e. government bonds) and the interest rate on these loans falls.  Deteriorating business climate and sales expectations causes money interest on unsafe loans to rise.  All this leads to a fall in security (bond) prices, resulting in more liquidation.  The Decree and the Indus lead up to a falling commodity (raw material) prices, leading to bankruptcies among commodity producers.  Downward deflationary spiral, i.e. falling prices in everything means existing dollars buy more.

Editors comments.  Circulation velocity must be the same as money velocity, which is the ratio of new money created to the total money stock, which must be a measure of the public’s propensity to hold cash rather than deposits, that is of hoarding money.  That is, money under the mattress cannot make new money in the same way that the same money could if it were held as bank reserves.

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