Comment worth posting and Interesting!

Comment worth posting
May 15, 2009 12:36 PM
anindya said...
One of the greatest "Great Depression" myths

One of the most thoroughly ingrained of today's many economics misconceptions is that the 30% decline in the US supply of money during the early 1930s CAUSED the Great Depression. This misconception, which probably began with either Irving Fisher or Milton Friedman, has been fully embraced by Ben Bernanke. That's why we should expect a lot more Fed-engineered growth in the money supply once it becomes clear that the economy is failing to recover despite (because of) the government's massive fiscal stimulus.

It can be shown using deductive logic that creating money 'out of thin air' -- counterfeiting, in other words -- can't possibly help the economy at any time. And for those who believe that "depression-era economics" warrants a novel approach, it can also be logically shown that conjuring-up new money can't aid the healing process after a giant credit bubble has formed and popped.

Unfortunately, it seems that many in the economics profession today don't trust logic. As a result, they cannot be swayed by a logical argument regardless of how well it is constructed. What they demand is that any assertion be 'proved' via data. The problem is, economic data can be interpreted in many ways and the same data can often be used to support opposing theories.

We don't mean to imply that historical economic data should be ignored. The point is that in order to interpret the data correctly you must START with the correct economic theory. For example, if you have a good theoretical understanding of why creating money out of nothing could never strengthen an economy then you will realise that, all else remaining equal, the economic situation during the early 1930s could not have improved if the Fed had managed to create enough new money to offset the monetary deflation of the period.

While we can't replay the 1930s to show what would have happened if the Fed of that earlier period had been able to do what today's Fed has thus far been able to do (promote sufficient money-supply growth to more than offset the monetary effects of the de-leveraging and the flight to safety), there is a relevant historical example to draw upon to reveal what possibly could have been. The relevant example is known as "The Panic of 1819". Here's an excerpt from a Mises.org article that discusses the lead-up to the Panic, the Panic itself, and the government's response:

"To add injury to insult, the men who ran the central bank "jumped on the inflationary bandwagon" themselves (Dupre 2006, p. 271). Printing paper and promises with Bernanke-like abandon, within two years of its creation they had loaned $41 million worth of gold promises and issued paper bank notes redeemable in gold worth $23 million, all on top of just $2.5 million worth of gold (Dupre 2006, p. 270), a level of leverage insane enough to make a Lehman Brothers risk manager feel right at home.

"Flood[ing] the market with bank notes it could not now redeem" (Dobson 2002, p. 105) between 1816 and 1818, the supply of paper bank notes and credit on the US market grew by 40.7%, "most of it supplied by the Bank of the United States" (Rothbard 2007, p. 87). The Philadelphia and Baltimore branches of the bank would prove to be the most profligate -- and the most corrupt -- of all.

The economic dislocations gained steam throughout 1816-1818, and prices in real estate, land, and slaves floated upward on credit. As 1818 feverishly arrived, though, it was only the greatest of the fools who were buying. The music would soon come to an end since the postwar prosperity was built on a foundation of nothing more than pieces of paper with promises scribbled on them. In the actual vaults, there was precious little money (the pledged gold) at all.

Soon enough this became a problem, as notes from the Bank of Kentucky promising gold wouldn't sit well with a merchant from Liverpool, England. Foreign merchants demanded payment in money, not paper. Plus, payment was coming due for the Louisiana Purchase and the French also wanted gold, not paper. The central bank was responsible for coming up with that money. Foreseeing disaster, it slammed on the monetary brakes.

So recently the Johnny Appleseed of credit, the Bank of the United States now returned as a loan shark's heavy. In one hand they held the state bank notes, with the other they demanded the gold pledged by them, which the state banks had little of.

When it was realized that many paper bank notes were just that, their values began to collapse, many to zero (the same amount of gold you could get for it), and the money supply contracted at a ferocious rate. From the fall of 1818 to the beginning of 1819, demand liabilities at the central bank fell from $22 million to $12 million (Dupre 2006, p. 272) and the total money supply fell about 28% (Rothbard 2007, p. 89).

Insolvent banks and overextended debtors alike collapsed, while prices, no longer pumped up by the bubble, raced downward to their equilibrium. As the money supply cleansed itself of the bad apples, time and effort had to be paid so that the flow of funds could adjust back to their best uses, following prices as their guideposts. It was a massive, countrywide downturn, and introduced a slowly industrializing America to a new experience -- mass unemployment.

Compared to now however, the state and federal politicians did basically nothing to "help" the economy recover from the Panic of 1819, yet by 1821 the economy had begun to get back on its feet, which must seem a stunning outcome to anyone burdened with a degree in economics."

The main points are that: a) the financial collapse of 1819 and the ensuing severe economic downturn were consequences of the preceding rapid expansion of credit, b) the money supply contracted by almost as much during the Panic of 1819 as it did during the early years of the Great Depression, although at an even faster pace, c) the government did very little to 'help' throughout the Panic, and d) by 1821 the economy had returned to a sustainable growth path.

Most of today's economists would be mystified by the ability of the US economy to heal itself following the Panic of 1819. And they would be completely dumbfounded by the fact that between 1839 and 1843 the US money supply contracted by about one-third (a monetary contraction of similar magnitude to that of the Great Depression) and wholesale prices fell by an average of 42% in parallel with robust economic growth and almost full employment*.

During the first half of the 19th Century the US Federal Government generally took a 'hands off' approach to the economy. This was fortunate for the people of that era because if the government had, instead, operated along similar lines to the Hoover, F.D.Roosevelt, Bush or Obama administrations then it's likely that the "Panic of 1819" would now be known as the "Great Depression of the 1820s" and the deflationary growth period of 1839-1843 would now be known as the "Great Depression of the 1840s".

*Refer to "III - Retrenchment in Crisis" in the article posted at http://mises.org/story/2201 for a discussion of the 1839-1843 deflation and a comparison between this period and the deflation of the 1930s.