True freedom

"Freedom means that in some measure we entrust our fate to forces we do not control; and this seems intolerable to those positivist / rationalist who believe that men can master his fate; as if civilization and reason itself were the fate of his making"
F.A. Hayek

Monday, July 15, 2013

A Review of the Monetary Phase of the Great Depression

A Review of the Monetary Phase of the Great Depression
By: Pablo Paniagua
Date: 7/12/2013

The Digital free PDF version of this essay is here

The Great Depression was without a doubt the most catastrophic event in economic history ever since the Black Death in the XIV century. Frequently people see the Great Depression (GD) as an isolated incident, specifically seeking to identify a single culprit that might have caused or ignited the depression: greed? Wall Street speculation? The Fed? Individuals usually seek to focus on a myopic, simplistic view of the GD rather than seeing it as a complex historical event that unveiled itself through almost two decades and that it contains elements of both economic policy and public policies, which makes the GD a more intricate and complex event. However as a matter of simplicity we can identify four major phases (Reed, 1981) or aspects of the GD that can be analyzed somewhat individually (although policies and phases do overlap). The first of these four stages is the monetary phase and the business cycle period, which encompasses 1922-1933. Subsequently the Hoover administration phase and the paving of the road on public policy for the New Deal; this stage analyses the Smoot-Hawley Tariff and other policies of the Hoover administration between 1930-1932. Third was the New Deal itself and FDR period, 1933-1938, and finally The Wagner Act and WWII period. It is impossible to understand the severity of the depression and why it lasted so long without having a holistic view of all of these phases and the evolution of ever increasing catastrophic public and monetary policies involved. 

The scope of this essay will be mainly to focus on the first phase of the Great Depression in particular its monetary phase. We will review the monetary policies in the 20s and 30s; specifically we will review the expansionary monetary policies that influenced the late booming years in the 1920s and finally the period of the Great Contraction between 1929 and 1933. Most commentators start analyzing the monetary phase of the depression from 1929 onwards; however we believe that the booming period of 1922-1928 will be a great theoretical foundation to understand the underlying disorganization and structural problems that ignited the subsequent phase of monetary contraction in 1929. These two periods of monetary policy are particularly characterized by contrasting intellectual and policy positions that created two different policy environments concerning money (Timberlake, 2013).  The first part of the monetary phase is marked by the (at the time) new regime of the Federal Reserve System, established on December 23, 1913 as a centralized federal response to the national bank panic of 1907. By the beginning of the 1920s, the Federal Reserve was just becoming self-aware of the potential power they might possess in controlling the money supply, but already by 1922 the Fed was actually very different from what the Federal Reserve Act original intended (Timberlake, 2008). By that year, the Federal Reserve started drastically changing their form of influencing the economy. The Fed moved from utilizing the discount window towards utilizing open market operations on government securities (Meltzer, 1976), this policy became in the twenties the standard mechanism to influence the money supply.

By the time the Fed was established, Benjamin Strong had become the appointed governor of the Federal Reserve Bank of New York, a position that he maintained until his death in 1928. He was a sturdy first governor of the Federal Reserve Bank of New York and as well as a substantial leader of the Federal Reserve System during the twenties. He exercised a disproportionate prominence in the policy decision making of the Fed during that decade, due to his relative importance as governor of the Federal Reserve Bank of New York and his former presidency of the Banker’s Trust.

As mentioned before the monetary policy of the twenties under Strong was in radical demarcation, both theoretically and practically, from the periods that followed during the thirties. By 1922 the main instruments of monetary policy started to radically change, under the leadership of Benjamin Strong, the Federal Reserve started to move away from transmitting monetary policy only through the discount window. The board wished to avoid the discount rate to guide the lending activities of the banking system, and seek a way to make the discount rate secondary, instead of the main Fed policy (Meltzer, 1976). The Strong policy framework then, shifted towards utilizing open market operations of purchases of government securities to try to guide the lending activities and the money supply in the banking system. Strong therefore led policies by 1922 onwards, deeply influenced in the quantitative theory of money developed by Irving Fisher that aimed at a form of price stability, in other words, Strong was seeking to control the expansion of the quantity of money in order to maintain a measure of the Consumer Price Index inflation stable. This decade was characterizing by solid and fast economic growth and fairly stable prices, which led people to believe that the U.S. had indeed entered a new era of stability and affluence. We have to discuss this decade more in detail in order to understand why the new era of affluence didn’t turn out to be viable. In order to do so, we will specifically review how deep structural imbalances can form in the economy even if there is an environment of price stability and then how these imbalances (once they turned out to be unsustainable) led to particular instabilities in the banking system and the stock market.

It is important to stress that not the entire economic boom of the twenties was unsustainable or excessive; as a matter of fact, much of the economic growth in the first half of the decade was sustained by real economic reforms that led to great increases in productivity and innovation.  The Coolidge era was particularly important in creating the political framework to sustain this entrepreneurial driven era. Substantial reforms and reductions on income taxes were implemented, Coolidge eliminated the income tax for nearly two million Americans (Sobel, 1998), by 1927 only the wealthiest two percent of Americans were paying income tax (Ferrel, 1998) and other commercial tax reductions created a more propitious environment to enhance economic activity. The policies fostered new consumption of the upcoming electric appliances and improved the tax environment allowing more competition and innovation.

Between 1923 and 1929 substantial reforms were similarly made on trade regulations and substantial improvements on interstate commerce. In addition, Coolidge substantially reduced Federal expenditures and retired nearly a quarter of the Federal debt (Ferrel, 1998).  Despite these reforms, President Coolidge was by no means a laissez-faire president; rather he was a deeply committed Federalist (Ferrel, 1998). We can see how Coolidge’s policies were aimed at improving the business environment substantially; the U.S. economy enlarged its real GNP by 4.2 percent a year and its per capita GNP by 2.7 percent a year from 1920 to 1929 (Smiley, 2010). Therefore we must be very careful in defining the Roaring Twenties as simply one big bubble, because there was a real solid economic growth which only later in the decade became “adulterated” to a certain degree through the Fed’s monetary policies.
By 1923 right after a mild recession of 1920-1921, the Fed started to sell securities and increased the discount rate from 4% in order to “cool” the recovery that according to Strong was accelerating too rapidly in early 1923. However by the end of that year there were some signs of a mild contraction, due to exogenous shocks of international oil prices (Smiley, 2010); this problem manifested itself late again in the decade in 1927, with a similar response by String. These oil shocks were seen as potential threats to the US economy, and were ameliorated with accommodative expansionary monetary policies. Benjamin Strong, through the years 1923-1928, started using securities purchases to seek to ameliorate and ease these exogenous threats to the economy. Therefore by 1923-1924 the Federal Reserve started its expansionary polices with large security purchases and reductions of the Federal discount rate, which manifested themselves in an increase of the securities holdings of the Fed by over $700 million in less than 4 years (Wheelock, 1992).

Following the 1923-1924 expansion, the Fed also reduced its discount rate from 4.5 percent to 3 percent, allowing banks to borrow money from the system at a lower discount rate. Another key element that contributed in the years of the monetary expansions was Benjamin Strong’s international economic commitments and international sensitivities. Strong was probably one of the only American economists and policy makers deeply interested in the troubled financial situation of Europe in the 1920s (Meltzer, 1976), particularly the 1925 British attempt to move back to the gold standard and to return to the old pound/dollar exchange rate of $4.85 that pushed Britain to a path of deep deflation (Skidelsky, 2005). In order to achieve this policy of a higher exchange rate Britain needed to keep gold reserves in Britain; this meant keeping interest rates relatively high compared to the rest of the world in order to attract gold reserves or to avoid them leaving the country. The higher interest rates also led to heightened pressure in the economy (Skidelsky, 2005).  Strong therefore helped sustained British monetary policies by reducing American interest rates through lowering the bank discount rate and increasing the supply of credit and lowering interest rates in the Unites States. These polices helped to somewhat reverse the flow of gold back to Great Britain, helping Britain’s attempt to return to the gold standard (eventually Britain broke from the gold standard in 1931).

By 1927 the Fed undertook its second biggest purchase program during its international commitment to allow Britain and France to return to the gold standard. Strong started adopting more severe expansionary measurers than the ones it had adopted before in 1924 (Selgin, 2013). The Fed reduced the discount rate once again and committed itself to large securities purchases, this time another extra $300 million, allowing France to return to the gold standard with an undervalued currency by 1928 and allowing Britain to contain the gold outflow and meliorate their 1927 payment crisis (Wicker, 1966). Overall we can realize how the period 1923-1928 was marked by a somewhat volatile and accommodative expansionary monetary policy that allowed the money supply to grow quite rapidly compared to the years 1921-1923. When these policies are seen as expansionary of a 5 year trend, we can see that by the mid-20s part of the real growth that the US economy was experimenting started to experience underlying assets inflation and profound structural distortions on relative prices. On this perspective according to Hayek and other Austrian economists, the twenties were a period in which some of the expansive monetary policies started to create by the late 20s a phase of unsustainable growth due to distortions on the relative prices and alterations in the capital structure of business; this economic discoordination was obscure and unintelligible due to the stable price policy enacted by Strong and the exacerbated optimism of the rampant real growth experienced in the early twenties. According to Hayek’s theory of the business cycle, these underlying misallocations of capital and this disorganization due to monetary expansion at some point had to be recognized by market forces, making a correction unavoidable (Hayek, 1932). Now a recession according to Hayek’s view would have been a form of restructuring business structures, capital formations and investments time-frames, this liquidation does not have to entail general prices and income deflation driven by monetary contraction, as a matter of fact Hayek never advocated liquidations and monetary contractions as a solution to the restructuring of the business cycle (White, 2008). Hayek was as antagonistic to monetary contractions as to disproportionate monetary expansions (White, 2008).

Hence, following a Monetarist policy of price stabilization through the quantifiable management of the quantity of money through the open market operations which, was the monetary policy proposed by the economist Irving Fisher. The policies advocated by Fisher are currently known as Monetarism, but at the time were known as the “quantity theory of money” (QTM), which looked at a macro level of monetary aggregates to aim at a “desired policy” of a relative stable growth of the money supply in order to keep inflation relatively low and under control. Strong through the open market operations from 1923 onwards achieved this macroeconomic goal quite successfully, maintaining a stable level of prices between 1922 and 1928. In fact between 1922 and 1929 the Consumer's Price Index (CPI) stayed practically constant, with a slight increase of 2.3 percent over those 7 years; in addition, the Wholesale Price Index actually decreased by almost 2.3 percent (Timberlake, 2013).

Differing from these price stabilization policies, the Austrians highlighted that by the 1924-1928 period the U.S. had seen the Fed incurring quite large operations of monetary expansion that started to overtake the real underlying growth of the economy, beginning to plant the seeds of a possible economic restructuring or recession, due to the distortions that this expansionary policy was creating on the signaling mechanisms of the borrowing interest rates and the relative prices of goods and capital. Hayek and Robbins opposed Strong’s price stabilization policies, believing that the “U.S. price level should have been allowed to decline as real output grew with productivity improvements of the 1920s. Instead in their view, the price level has been artificially propped up by the Federal Reserve’s credit expansion” (White, 2008, p.756). Following this critique, in the words of professor Selgin: “According to several economists, most notably Hayek and Lionel Robbins [at the time], the Great Depression began, not as a response to post-1929 deflation, but as the collapse of a prior ‘malinvestment’ boom fueled by the Fed’s easy money policy of the latter 1920s” (Selgin, 2013, p.14, emphasis mine).

We have to note, from the past statements, that the main critique to the “quantity theory of money” is that a monetary policy that uniquely aims at a simple evaluation of broad macroeconomic aggregates will evidently obscure and muddle our deep understanding of the microeconomic foundations of the market signals, specifically relative prices of goods and services and borrowing interest rates that coordinate at a micro level the decisions of thousands of individuals. The distortions engendered on the market signals are unfortunately unrecognized and ignored under a broad macroeconomic approach such as the one advocated by Irwin Fisher. Hayek during the 20s and 30s distanced himself from the QTM due to the fact that the interaction of relative prices and the theory laid in a comparative static approach that obscured the relevant facts of the dynamic market process and coordination (O'Driscoll, 1977). In a nutshell Hayek and other Austrian economists thought that a macro aggregated quantitative approach to monetary policy had three major erroneous suppositions or implicit suggestions:

    “Firstly, that money acts upon prices and production only if the general price level changes, and, therefore, that prices and production are always unaffected by money, -that they are at their “natural” level, -if the price level remains stable. Secondly, that a rising price level tends always to cause an increase of production, and a falling price level always a decrease of production; and thirdly, that 'monetary theory might even be described as nothing more than the theory of how the value of money  is determined” (O'Driscoll, p.46, 1977).      

These erroneous propositions then inhibited Strong in grasping the secular and accumulative harmful effects that expansionary monetary policies carried on the capital structure and on the overall capacity of the market of efficiently coordinating value enhancing economic activities, which ended by eroding the healthy economic growth of the early 20s. As a lesson of these 1920s problems with monetarism, and later also in the 2000s, we can see as professor White points out: “consumer price inflation [and other economic aggregates] is [are] not our exclusive concern. The past decade has reminded us that, even with consumer inflation rates around 2.5 percent or lower, we face the serious danger of asset price bubbles and unsustainable credit booms under a central bank policy of artificially low interest rates” (White, 2013, p.19). This comment by Professor White is a clear reminder of the role of interest rates and prices in coordinating the micro foundations and the capital structure in the real economy, which could suffer from hampering processes of coordination that are unfortunately unobservable through the aggregated measure of price inflation indexes.
In October 1928 Strong died of tuberculosis and finally a different intellectual framework took over the Fed polices (Friedman and Schwartz,1963); the monetarist policies of price stability led by Benjamin Strong, based on the macro economic theories of Irwin Fisher were no longer fashionable at the Fed. Consequently the Real Bills Doctrine supporters on the Fed Board took control over the monetary policy of the country by 1928. George Harrison, the successor of Strong at the New York Fed, lacked the commitment and Strong’s intellectual framework to continue Strong’s policies of monetary stability (Timberlake, 2008). The Real Bills Doctrine, in the hands of Adolph C. Miller, a senior member of the Board of Governors that openly had criticized Strong’s QTM policies during the mid-20s, had started to emphasize a control of the money supply according to the “needs of trade”. The Real Bills supporters believed in expanding credit whenever real economic activity was booming and contracting credit whenever real trade and commerce stagnated; in this fashion then “the stock of money and bank credit rose in periods of economic expansion and declined in recessions” (Meltzer, 1976, p.3). In addition, this doctrine condemned banks for lending for speculative motives and tried to discourage long term borrowing (Timberlake, 2008 and 2013) which, according to their views, might have fueled the stock market and real state bubbles in the late 20s. The Federal Reserve, right after Strong’s death, started contracting credit at discretion and started promoting an anti-speculative agenda. On February 1929, the Fed Board sent a letter, expressing Miller’s opinion to the rest of the Fed Banks, stating the Board’s new duties:  

“[Our new] duty . . . to restrain the use of Federal Reserve credit facilities in aid of the growth of speculative credit.”[…] [They initiated] “The policy of ‘direct pressure’ [which] restricted borrowings from the Federal Reserve banks by those member banks which were increasingly disposed to lend funds for speculative purposes” (Miller, 1935, p. 453 via Timberlake, 2008).

This new policy created a sturdy discriminatory bank borrowing procedure that led to a huge systemic contraction in the borrowing capacity of banks that also culminated in the transmission of a great contraction of credit to the overall public, this created a sever contraction in the supply of money and an overall massive contraction of the money in circulation. The discriminatory and arbitrary lending procedures also rendered the discount window of the Fed almost meaningless (Timberlake, 2008), arbitrary decisions to whom to lend, created direct pressure on banks and exacerbated bank failures. These arbitrary discriminatory policies of the Fed Board of Governors created three consecutive banking crisis in 1930, 1931 and 1933 (Timberlake, 2013), contracting the money supply by nearly 30%, without a significant recovery. Unemployment started to rise rapidly with the dreadful monetary policies of the Fed, from 3.2% in 1929 to 8.9% by 1930 and arriving to catastrophic levels of more than 25% by 1933. So what could have been a mild recession in 1929 was, by 1933, already a debacle. Unprecedented reckless and erroneous political and monetary policies exacerbated what could have been only a normal recession and a short-lived healthy restructuring of the sound real economic fundamentals of the early 20s. However the Fed’s misguided policies turned the recession into a depression never seen before in history, prolonging the self-inflicted liquidity crisis well into the mid-30s. By 1933, “the M1 and M2 money stocks were 27 percent and 25 percent below their 1929 levels. Meanwhile, the Fed Banks sat on their huge hoard of gold—the gold reserves legally required for their current monetary output and the “excess” gold reserves that could have provided significant monetary increases—and did . . . nothing!” (Timberlake, 1999). On this line of argument, Schwartz (1981) has showed how since 1929 until the mid-30s the monetary growth was nonexistent and this contraction in the money supply is the best evidence of a very tight arbitrary monetary policy led by the Real Bills Doctrine. The money stock therefore fell by almost one-third between 1929 and1933 (see Figure 1).      

In consequence by 1928 the expansionary policies of Benjamin Strong over the years 1923-1928 started to seem unsustainable and dangerous under the Real Bills Doctrine framework. As a matter of fact the rest of the Fed Board of governors, following the Real Bills Doctrine, saw cheap credit and long-term borrowing as something inherently unhealthy and corrupt for the economy (Timberlake, 2013). Another explanation of the failure of the Fed to provide liquidity during the 1929-1933 periods was according to Meltzer (1968 and 1976), the failure of the Fed officials in distinguishing between the market interest rate and the real interest rate and their role in the business activity. At the time, Meltzer argues, the Real Bills Doctrine followed a classical approach of monetary policy in which monetary interventions were supposed to affect short-term nominal market interest rates. Nominal Market interest rates therefore were, for the Real Bills Doctrine, the main indicator for monetary policy. Whenever nominal market rates fell, then monetary policy was considered expansive or loose; on the other hand, when nominal market rates were relatively high, monetary policy was seen as contractionary. By the summer of 1930 the short-term nominal market interest rates were at their lowest levels in a decade (Meltzer, 1968) and the short-term market rates of Treasury notes continued to fall. However, this decline on the nominal market interest rate was mainly due to price deflation, a severe decline of the monetary base, a severe decline in the demand for business loans and a tight supply of liquidity (Meltzer, 1968). Unfortunately as market rates were falling, Fed officials interpreted this as a reflection of secular accumulated “extremely easy” monetary policies, which refrain them to increase the money supply at a moment the system needed it the most:      

“[…] most of the members of the Open Market Conference believed that policy remained "easy." In their view there was no reason to produce increased "ease." In fact, several of the members believed that monetary policy was much too "easy" during this period [1930-1931] and recommended a policy of open market sales [contractionary policies].” (Meltzer, 1968, p. 12)  

In addition to this failure of understanding the role of interest rates by the Real Bills Doctrine, the Fed by 1928 started to look with increasingly worries at the drain of its gold reserves and the faster than ever rise in the stock market. The Fed therefore started to adopt arbitrary contractionary polices through the selling of securities and, in three steps, raised the discount rate from 3.5% to 5% by July 1928. Discount rates were finally raised again a fourth time to an unprecedented 6% percent in August of 1929. By that time the massive contraction of money had already begun and the lack of liquidity in the banking system was already a systemic problem. In late October the stock market crashed as a consequence of the monetary contraction, and this finally led to a catastrophic collapse in nominal spending, real GNP fell from 1929 to 1933 by 33 percent and the subsequent banking crisis that developed as liquidity by the Fed was drying up (near 9,000 banks with $6.8 billion of deposits failed), sliding America into the Great Depression (Wheelock, 1992).
The contrast of both of these schools of thought that shaped the monetary policies of the U.S. could not have been more accentuated. The clash of views, concerning how to manage the money supply before 1928 and after 1928 is of extreme relevance to understanding money and our human capacity to manage it. This point is of particular importance, as Milton Friedman and Anna Schwartz’s Monetary History have shown us, the clashing schools of thought concerning monetary policies led to the most tumultuous times in our economic history. The great American economist Irving Fisher testified before Congress in 1935 regarding the Great Depression and stated: “Governor Strong had died and his policies died with him […] I have always believed, if he had lived, we would have had a different situation.” We clearly see the demarcation between schools of thought regarding monetary policy, how they were represented by individuals at the Fed and how they affected the Fed’s decisions. On one side, there was the discretionary and extremely arbitrary Real Bills Doctrine that conditioned credit at discretion, based on arbitrary decisions of the Board of Governors. On the other side there was the less discretionary more “quantitative based”, ‘technical’ price stability policy. How these different schools of thought determined the destiny of the economic system from 1923 until the mid-30s is an incredible case study of the power of ideas and a lesson on the danger of centralized decisions concerning the money supply; additionally under this centralized monetary system, the economy is very susceptible to changes in the ideas and passions of fallible men rather than being based on the real underlying market processes and fundamental economic conditions.

From this experience we can see that Monetarists such as Fisher and Friedman considered that if the Fed would have continued to follow Strong’s monetary policies, the collapse of the economy would have never been as severe as it was. On the other hand, Austrians such as Hayek and Rothbard and other scholars argue that if Strong’s policies would have continued, this would have only perpetuated a secular dreadful negative underlying condition of price distortions and misallocation of capital, which would have just keep accumulating and prolonging even more harmful misallocation and economic discoordinations. Regardless of the differences in views and policy, we believe that the major take away from these ideological and theoretical problems concerning money is that the greatest danger of using the incorrect monetary framework originates from the fact that decision making was made in the 20s and 30s and is still very much used today under a centralized intellectually monopolistic fashion. This creates the danger of getting things wrong extremely dangerous, since the mistakes of few man will have severe repercussions at a systemic level.

The best way to avoid large catastrophic centralized mistakes on human decision making is through a monetary framework which encourages decentralized decision making, minimizing human mistakes and facilitating a learning process through which the banking industry can be extremely benefited. When the Fed affects the money supply through centralized policies and by relying excessively on the views and passions of a few men in order to make complex decisions for the sake of the whole banking system (thus for the rest of the economy), it puts, hazardously, extremely high faith on concentrated decision making and increases the systemic risks that those few people could make bad decisions for the rest of us. Instead a rather decentralized banking system, although not perfect, could have coped better with the liquidity crises through a dispersed system of trial and error in monetary policy making. This sort of system would make additional but smaller less riskier strategies, minimizing the jeopardy of enacting bad policies for a large part of the banking community. This in turn increases the discovery and learning procedures for the rest of the banking system, in which they can imitate or correct, polices that would have worked better in order to provide systemic liquidity. Friedman and Schwartz recognized this point emphatically when declaring: “[I]f the pre-1914 banking system rather than the Federal Reserve System had been in existence in 1929, the money stock almost certainly would not have undergone a decline comparable to the one that occurred.” Friedman & Friedman in Free to Choose again argued:

“Had the Federal Reserve System never been established, and had a similar series of runs started, there is little doubt that the same measures would have been taken as in 1907—a restriction of payments. […] restriction [of payments] would almost certainly have prevented the subsequent series of bank failures in 1931, 1932, and 1933, just as restriction in 1907 quickly ended bank failures then. . . . The panic over, confidence restored, economic recovery would very likely have begun in early 1931, just as it had in early 1908” (Friedman & Friedman, 1990).

Following this line of argument then, we see how prone to failure a centralize banking system stands, and how systemically dangerous is for an economy to allow excessive centralisms of fundamental market functions on just elucidations and ideas of few “wise individuals”. Friedman and Schwartz (1963) commented on this the following:       
“It was a defect of the financial system that it was susceptible to crises resolvable only with such leadership [of single individuals]. The existence of such a financial system [a centralize one] is, of course, the ultimate [and fundamental] explanation for the financial collapse, rather than the shift of power from New York to the other Federal Reserve Banks…”

It is worth mentioning that on neither of these monetary policy theoretical environments (under Strong or under the Real Bills Doctrine), the gold standard had a significant role to play (Timberlake, 2013), even if the gold standard was the official monetary system of the Unites States. Ever since 1913 the real monetary policies were being dictated capriciously by the Federal Reserve Board despite of the gold standard, thus the gold standard was de facto a faรงade, “[…] the movements of gold into and out of the United States no longer even approximately determined the economy’s stock of common money” (Timberlake, 2008). The stabilizing properties of the dynamic adjustment process of the gold standard were not able to work during the price stability policy led by Strong or during the Real Bills Doctrine after 1928. Thus the gold standard was neither capable of contracting credit in the boom years nor supplying credit at the times of depression; gold was therefore not the mechanism in which monetary policy was based upon. In other words: “If a gold standard is managed by a Treasury Department or a central bank, it is no longer a gold standard” (Timberlake, 2010). Under this perspective, the Great Depression is hardly the gold standard’s fault but rather the fault of discretionary expansions and contractions led by the Fed. As Leland Crabbe, a Board of Governors staff member, mentioned at the time: “because the gold reserve requirement [that the Fed possessed] rarely restrained policy between 1914 and 1933, the Federal Reserve had broad discretionary powers to manage the nation’s money supply in the advancement of domestic [nationalistic] objectives” (Selgin, 2013).

Thus ever since the establishment of the Federal Reserve System in 1914, the Fed started to evermore move towards a complete sense of management and control of money: “mortal men and not the market were controlling the monetary policy and while doing it, they imposed their biased beliefs and prejudices in front of the gold standard, rendering the gold standard superfluous” (Timberlake, 2010). (Although the gold reserves provided a mathematical limit concerning the Fed Banks capacity of expanding credit). This finally created a system in which the Fed, through their Fed banks, somewhat controlled the quantity of money. Immediately following Strong’s death, if the U.S. would have moved to a real Gold Standard by early 1929, then decentralize commercial banks would have had the control of their own gold reserves and they would have expanded credit at their individual discretion, counteracting the contraction (Timberlake, 2013). Instead the Real Bills Doctrine at the Fed, centralized the hoarding of gold reserves at the Fed banks and arbitrarily started to negate credit to sound banks on liquidity troubles, violating their own regulatory ethos stated in the Federal Reserve Act. This exacerbated the contraction in the direction of the Great Depression and opened the gates for radical intellectual and social changes in the United States. The nation then moved away from the gold standard and the Federal government enacted the foundations of Social Security; it is beyond doubt that the Great Depression changed our political, economic and philosophical framework forever as a nation and this alone is enough to justify the expression “money matters.” 

Figure 1:
Source: Wheelock, 1992

-          Ferrel, Robert H.; The Presidency of Calvin Coolidge; University Press of Kansas; 1998
-          Friedman, Milton, and Anna J. Schwartz;  A Monetary History of the United States, 1867-1960 (Princeton University Press, 1963)
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-          Hayek, Friedrich; Monetary Theory and the Trade Cycle; Republished by Martino Fine Books; [1928] 2012
-          Hayek, Friedrich; Prices and Production and Other Works; Reprinted by Ludwig Von Mises Institute; 2013, [1932] 
-          Laidler, David; The price level, relative prices and economic stability: aspects of the interwar debate; BIS Working Papers No 136; Monetary and Economic Department September 2003
-          Lawrence W. Reed; Great Myths of the Great Depression; Center and the Foundation for Economic Education; 1981.
-          Meltzer Allan and Brunner, Karl; What Did We Learn from the Monetary Experience of the United States in the Great Depression?; , Carnegie Mellon University, Research Shocase, Tepper School of Business, Paper 633, 1968
-          Meltzer Allan; Monetary and Other Explanations of the Start of the Great Depression, Carnegie Mellon University, Research Shocase, Tepper School of Business, Paper 689, 1976
-          O'Dirsocll, Jr., Gerald; Economics as a Coordination Problem, The contributions of Friedrich A. Hayek; The Institute for Humane Studies; 1977
-          Schwartz, Anna J. “Understanding 1929-1933,” in Karl Brunner, Ed. The Great Depression Revisited (Kluwer- Nijhoff, 1981), pp. 5-48.
-          Selgin, George; The Rise and Fall of the Gold Standard in the United States; Cato Policy Analysis Number 729; June 20, 2013
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Monday, April 15, 2013

Book Review: The Battle of Bretton Woods; John Maynard Keynes, Harry Dexter White, and the Making of a New World Order

Book Review:  The Battle of Bretton Woods; John Maynard Keynes, Harry Dexter White, and the Making of a New World Order                                                               
By: Pablo Paniagua
April 8, 2013

Book details:

Name: The Battle of Bretton Wood; John Maynard Kaynes and
Harry Dexter White, and the Making of a New World Order.
Author: Benn Steil
Hardcover: 456 pages
Publisher: Princeton University  
ISBN: 978-0-691-14909-7
Release date:  February 24th, 2013

“[…] the illusion that government monopoly would secure for the countries a better money than the market has governed all the development of monetary institutions ever since, the fact is of course that wherever the exercise of this power was not limited by some such automatic mechanism as the gold standard, it was abused to defraud people. A study of history of money shows that no government that had direct control of the quantity of money can be trusted for any length of time not to abuse it.”
F.A. Hayek

“If the Enlightenment has discovered that the role assigned to human reason in intelligent construction had been too small in the past, we are discovering that the task which our age is assigning to the rational construction of new institutions is far too big.”
F.A. Hayek

Right after the 2008 international financial crisis, that was partly caused by severe economic endemic instabilities and systemic financial imbalances. World leaders were advocating for a new international monetary order that would help us deal and manage such imbalances and to control and tame currency and capital fluctuations; which played a huge role in the gestation of the crisis. The voices were almost unanimous: leaders of the world were calling for “a new Bretton Woods”. It almost seemed that the future of the world’s economies will exclusively depend of a new form of international agreement design and led by translational institutions and bureaucrats; this vision is analogous to the one originally crafted in the remote town of Bretton Woods in New Hampshire in July 1944. How accurate is this vision of the world’s macroeconomic check and balances? How effective was Bretton Woods in creating a consciously design monetary regime?; Benn Steil’s splendid book raises this and several other questions concerning one of the most important events in the 20th century; that shaped the geopolitical landscape and the international monetary system towards a United States-based dominion for the last 70 years. And the vital consequences and lessons we can get for the future, from a sober demystifying analysis of Bretton Woods and our intellectual capacity of designing complex social institutions such as monetary systems.

Benn Steil is senior fellow and director of international economics at the Council on Foreign Relations. He was awarded with the Hayek Book Prize in 2010 for his book Money, Markets, and Sovereignty. His vast knowledge on currency wars, protectionist policies and international economics is the perfect background to tell the history of this unique international political-monetary event; his book encompasses not only currency manipulations and economic history but touches geopolitical analysis, espionage and well-documented biographic analyses. This general approach makes this book not a treatise on international economics or economic history but rather a stimulating engaging political and diplomatic history spiced up with backroom negotiations, intellectual-diplomatic duels and soviet spies.

The Battle of Bretton Woods offers a wider and amusing analysis on the political and economic international events prior, which lead to the Bretton woods agreements. It also reveals the details and the political influences that played a major role in the crafting of the new monetary system right after WWII. Steil’s vivid narrative jumps between geopolitical negotiations and international economics while telling us rich and deep portraits of the leading men involved in the intense negotiations, which led to the political and intellectual battle of Bretton Woods. The leading roles were performed by Harry Dexter White on the American side and John Maynard Keynes on the British side. The book indirectly deals with the historical diplomatic and economic context of the decades that marked one of the major geopolitical shifts of power in the world’s history, the decline of the British Empire and the surge of The United States as the major political and economic power; and how this remarkable shift, came, for the first time in history, enacted mainly through macroeconomics. It also shows, how the Bretton Woods monetary system, was undertaken by the vision of a single man Harry Dexter White and the explicit American instrumentalization of this new monetary system, which allowed the U.S. to enforced it to the rest of the world through the Bretton Woods ‘negotiations’, accomplishing the FDR’s government agenda of eliminating completely Britain as an economic and political rival.  

Bretton Woods represented a unique crossroads of economic and political power; it represented the political battle that gave an end to the British supremacy and the end of British imperialism and monetary hegemony and the rise of the U.S. economic supremacy and international free-trade; while also giving the U.S. dollar the role of the world’s main currency. The book shows this economic-political intersection represented in the face of two remarkably gifted men in the political-intellectual battlefield. The British side was represented by the savvy intellectual luminaire Lord Keynes which was at the time to world’s first and most famous and influential celebrity-economist; and on the American Side Harry Dexter White a short-tempered U.S. Treasury technocrat, New-Dealer Democrat and self-made economist from Harvard. The book beautifully portraits the problems and difficulties of Keynes on the British side to negotiate their terms in the discussions; specifically due to the lack of political sensitivity of Lord Keynes and mainly due to the fact that Britain was virtually insolvent and the U.S. was her major creditor. In addition, the Americans had the benefits of having the biggest gold reserves, being the main world lender after WWII and they counted on the political skills of White, which seized the perfect moment in time to bring the U.S. dollar as the world leading currency. White was no match for Keynes intellectuality, but White was on the American side and his bargaining position was total. The position of the U.S. as the major borrower allowed him to practically dictate and craft by himself the new monetary order that had the main objective of being the macroeconomic instrument to bring the U.S. as the new economic and political leader and impede foreign nations to arbitrary depreciate their currencies.

Steil’s animated narrative of the years that preceded the Bretton Woods agreement tells the political negotiations and the intellectual and political battles held multiple times by White and Keynes and others. Through these international battles we not only gained incredible insights on political negotiations and international manipulations; but we also gained beautiful portraits of the man that shaped the 20th Century. Here is where the books turn into a very diverse intellectual and narrative endeavor. This well documented book, moves constantly away from economic history and dives into American realpolitik, British politics and concise and rich intellectual biographies plus deplorable illustrations of government officials deeply involved with the Soviet Intelligentsia. This is a very appealing part of the book, which makes it more suitable for the general readership. In these personalities’ portraits, we gain very enjoyable insights of one of the very much neglected but yet fascinating figures of the 20th century: Harry Dexter White. Steil’s bring into light one of the most rich and controversial expositions on White’s life; in particular his secret connections with the Soviet Union and how White was secretly a promoter of Russian Political interests while at the U.S. Treasury. The Battle of Bretton Woods sheds light on Whites long-time affair with central planning and socialism, since his doctoral days in Which White wanted a scholarship to study abroad in Russia to learn socialist-economy. His passion for socialism and the soviet union, paradoxically did not play any role in his drafting of the U.S. led monetary regime, however through the designing and planning of the monetary system, we see how White’s saw (poorly)  economics simply as a mean to higher nationalistic and political ends.

The book then shows how White, while skillfully designing almost single handed, the world monetary system from the U.S. Treasury, he was simultaneously engaged in secret communications with Soviet  spies; facilitating confidential and sensitive information from the Treasury to the Soviet Union. White also consciously placed other several Russian fellow-travelers as full-time employees inside the Treasury. The book unmistakably represents White as probably one of the most important and influential Russian connections inside a governmental American position in the 20th century. In addition the book highlights the symbiotic political dependency between U.S. Treasury Secretary Henry Morgenthau and his right-hand advisor Harry Dexter White and how White through Morgenthau, directly influenced the international politics of Franklin D. Roosevelt’s White House. In particular, the book shows how White directly influenced and skewed the American-Japanese relationships that ended up in the Japanese retaliations on Pearl Harbor.  

At the end of White’s career he reached bureaucratic excellence within the U.S. Treasury under Morgenthau’s direction allowing him to create and draft the monetary system that would allow the U.S. macroeconomic international governance and hegemony. Through this two and a half years process of negotiations between the British and the Americans, the book glance interesting aspects of John Maynard Keynes; his political defeats in the Anglo-American negotiations, his obsession of leaving his personal stamp as the father of a new monetary system and his long-term compulsion of being internationally relevant at all cost. This extreme self-involvement ended up playing against the British government’s necessities and hampering their debt negotiations. At this point, the book give us White’s most brilliant political move: the actual organization of the Bretton Woods meeting at the perfect time and place that provided him with the perfect smoke and mirrors situation to blindside Keynes from the real negotiations concerning the U.S. currency hegemony. White divided Bretton Woods in two major commissions, the first one, dealing with the establishing of the international stabilization fund, currently the International Monetary Fund, and the settlement of a new international dollar-based monetary system, led by White; and the second less relevant commission that dealt with the International Bank for Reconstruction and Development, renamed in 1992 the World Bank which was led by Lord Keynes. White’s scheme worked perfectly, side-lined Keynes from the most relevant discussions concerning trade liberalizations and currency convertibility.  

Bretton Woods was therefore simply a charade to obscure the fact that the new world monetary system was a bilateral political prearrangement between the U.S. and Britain; that was being planned two and a half years before the conference itself and it was marked by nationalistic conflict of interests; such a short-sided political and nationalistic biased is one of the structural weakness that still reign in our current international monetary fiat system in the form of “monetary nationalism” and an international race to the bottom sort of monetary policy.   

Consequently, the structure of the new monetary system created by White at the commission became only fully operative after Bretton Woods, officially in 1961. The main feature of the post WWII Bretton Woods monetary regime was to seek a fixed exchange rates system for currencies and having the U.S. Dollar as the only currency directly pegged to gold at a ‘fixed exchange’ rate. The system obviously beneficiated the U.S. Federal government, allowing it to become the orchestra director of monetary policy in the world. This scheme liberated somewhat the Federal government discretionary powers, towards to consciously plan and managed the U.S. macro economy through accommodating monetary policy. Unfortunately, Steil argues, White’s design and the Bretton Woods agreement were very short-lived due to its inconsistencies and lack of internal tendency to control imbalances and the lack of restrain of the U.S. government to increase the supply of dollars devaluating the currency. The scheme ended only 10 years later in August 15, 1971 when President Nixon closed the gold window and ended any form of dollar convertibility to gold. These phases were marked with the tension and conflicting inconsistencies of trying to design a system, based on a national currency that seek to be both, the international settlements character and the national U.S. domestic monetary role. Steil stresses the inherent contradiction in White’s system, concerning how to provide enough liquidity as an international settlement currency, highly demanded internationally, while at the same time restricting its liquidity in order to keep the dollars redeemable to gold at the fixed exchange rate.

1971 concluded the last form of relationship of the U.S. dollar with gold and simultaneously opened the door the our new current system based on international fiat money; a system without tangible connection to any form of commodity, in which politicians and technocrats are freer than ever to follow arbitrary and nationalistic policies aimed at depreciating currencies and generating secular inflations that allows them intrinsically to increase secular discretionary government spending. Nixon’s decision to close the gold window could be seen only as the obvious most preferable political path available, under the road that White’s system had initially paved. The book shows us how political biased and governmental interests permeates the design of fundamental social institutions, creating deep structural institutional inconsistencies that leads to unstable economic systems characterize by unsustainable imbalances and credit expansions that have no  built-In counterweights to correct them as the classical gold standard somewhat offered instead.

The book leaves us with the sober conclusion about the possibilities and limitations of politicians and technocrats to consciously design an efficient monetary system that will take into account monetary imbalances and at the same time put checks on nationalistic arbitrary monetary policies. Bretton Woods, the book shows, was far from an international agreement in which every country had a saying in the making of the system. It was only a nationalistic political-macroeconomic weapon used by the U.S. Federal government to increase their political and economic power in the world and it was the greatest case in which the U.S. government came to instrumentalize something as fundamental to human prosperity as the monetary system. The book teaches us how, monetary systems and currencies are deeply attach to international politics and geopolitical power struggles; it also provide us a very interesting lesson of skepticism concerning the capacity to consciously and deliberately create competently something as complex as a monetary system.

Steil’s book in addition, periodically references the benefits of the first gold standard trough 1880-1913 and how even with all its faults and imperfections it still possessed a higher control on the level of discretion of central banks; it possessed an automatic built-in tendency in the system to control and contain international imbalances and credit expansions; ironically enough this monetary regime was neither design nor imposed; but it was unexpectedly shaped through a system of try and error. The original gold standard can be seen as a Hayekian social institution that aroused organically as a self-organizing structure, somewhat removed from nationalistic and political design and it gave birth to one of the most prosperous centuries in human history. In contrast, the gold-exchange standard after WWI, the Bretton Woods dollar-based gold-exchange standard and the international fiat money system as seen in this splendid book, were the results of consciously design, artificially fabricated, deliberate politically leveraged institutions that ended up creating unsustainable imbalances, wars and serial catastrophic bubbles opening the door to a century overwhelmed by volatility, long economic recessions and monetary distortions.

In conclusion this unique book is a delightful blend of politics, espionage and economic history. The book give us a fundamental lesson for future international economic arrangements; that we have to be aware of the limitations of our knowledge to consciously design such a intricate and relevant social institution as a monetary system and at the same time, raises awareness of the risks of allowing political and nationalistic interests to manage and control these systems at will, because as seen with Bretton Woods this will be the seeds of its own demise. These lessons that Steil’s book gives us today is a relevant modest lesson on the dangers of mixing short-sided political aims and  social institutions and is as relevant today as it would have been for the ‘enlighten’ ones in New Hampshire in 1944.   

“The Bretton Woods monetary system was finished. Though the bond between money and gold had been fraying for nearly sixty years, it had throughout most of the world and two and a half millennia of history been one that had only been severed as a temporary expedient in times of crisis. This time was different. The dollar was in essence the last ship moored to gold, with all the rest of world’s currencies on board, and the United States was cutting the anchor and sailing off for good.”
Benn Steil 

“The gold standard was, without any international agreements, the most satisfactory international standard that has ever been devised…It is often said that the gold standard ‘failed.’ The truth is that governments sabotaged it deliberately, because it interfered with nationalistic ‘planning’ that governments preferred to stability of exchange rates…It is not necessary to invent elaborate technical devices to secure monetary stability. The nineteenth century developed them through the gold standard.”
The New York Times March 30, 1943

Sunday, March 10, 2013

Book Review: Conscious Capitalism

Book Review: Conscious Capitalism: Liberating the Heroic Spirit of Business
By: Pablo Paniagua
February 19, 2013
Book details:
Name: Conscious Capitalism: Liberating the Heroic Spirit of Business
Author: John Mackey and Raj Sisodia
Hardcover: 368 pages
Publisher: Harvard Business Review Press
ISBN: 978-1422144206
Release date: January 15, 2013

This is what we know to be true: business is good because it creates value, it is ethical because it is based on voluntary exchange, it is noble because it can elevate our existence, and it is heroic because it lifts people out of poverty and creates prosperity.”
John Mackey
Early this year the co-CEO of Whole Foods John Mackey along with Raj Sisodia, a marketing professor at Bentley College, launched: Conscious Capitalism: Liberating the Heroic Spirit of Business. The book is a noble attempt to change the outdated obtuse managerial paradigm of the “way of doing business” while simultaneously stressing capitalism’s core virtues and noble moral foundations. The book challenges the way of perceiving companies as simply profit-maximizing machines squeezing stakeholders in order to achieve their narrow monetary ends and also warns us of how when we follow that narrative, we undermine not only our own companies but capitalism and society.
Conscious Capitalism offers a wider view as to how business in general should be perceived, specifically in this new era of interdependence and human-social consciousness. The book starts with Mackey challenging Milton Friedman’s outlook on business; Friedman once stated that the only genuine role of business was to be responsible only to their shareholders, with other stakeholders being beyond the realm of action for business. Today when connectivity and social global awareness have increased, this view seems to be too narrow and self-defeating. Additionally it does not explain how companies can add sustainable value to society through a network of relationships creating systems of collaboration, interdependency and win-win partnerships to enrich us all. This book is the authors’ attempt to expose management and society to this forgotten reality of capitalism and its inner heroic power of unleashing collaboration and well-being. Likewise Conscious Capitalism places special emphasis on the incredible role that entrepreneurs and companies play in modern society as well as in every aspect of life. Mackey helps us to realize how most of our daily interactions are related to various business forms or occur inside different work environments. Therefore it is imperative to have businessmen who are fully conscious of their crucial social role and aware of the direct impact they make on other’s lives and the environment. If we want to have a balanced society to make people feel fulfilled both spiritually and materially, Mackey argues is that we need a more conscious, holistic way of seeing business and a well-rounded conception of capitalism.
In order to share this awareness among entrepreneurs, the book shows that a radical change of paradigm is necessary for the way people manage and perceive their businesses and modify our view of what we understand as capitalism. If businesses want to become profit-oriented, while retain sustainable value, increase long-term profits and add value to the whole society, their only sustainable solution is to elevate their business scope towards a higher social purpose; which helps to create a shared integrated vision of society with their stakeholders. This higher purpose will appeal to others involved in their economic and social relationships, opening business towards more long-term beneficial relationships. Embracing ‘conscious capitalism’ is, according to Mackey, the way in which we can embrace real human and responsible entrepreneurship, which has been the true engine of progress in human society for more than 200 years. The only way to build accountable and successful business practices is to establish relationships based on love, care, respect and efficiency. This will benefit customers, employees, investors, communities, suppliers and the environment. The book illuminates the fact that capitalism is not based on rapacity and shallow egoistic self-interest but rather win-win relationships based on harmony and reciprocity. According to the book, people have failed to understand what true capitalism is about and how it creates prosperity; this is a menace for a free-society and its capacity to create spiritual and economical wealth. This book helps us to rediscover this forgotten reality.
Mackey’s book later evolves into his personal manifesto of the heroic roles that entrepreneurs have played in modern societies and how businesses are the institutions which can contribute to a more tangible way to our psychological and materialistic well-being. Unfortunately most business schools preach to some degree versions of a short-term, voracious, narrow version of business, which pushes business leaders around the world towards a simplistic erroneous paradigm. This mistaken vision aims only at seizing short-term monetary gains at whatever cost, even if it undermines the company’s own long-term success and damages workers and suppliers. The book proposes a new management paradigm instead: a holistic, value-centered and socially integrated company. This manifesto is a clear example of how capitalism and businesses can be ‘conscious’ trough converging the personal profit-seeking motives with higher social purposes that creates value and benefits for local cultures, workers, suppliers and the environment. There is no clash between society’s interests and those of profit-seeking industries; they not merely coexist but are fundamentally interdependent on one another.
The book continues by reminding us that the true hero in the capitalist system is the entrepreneur; it is he who elevates the quality of life to all mankind through serving it. Mackey then poses the following query: why is capitalism- even after being shown to be the best possible system in which humans can flourish- so repudiated by intellectuals and the masses? Businesspeople, Mackey argues, have been losing ground on defending capitalism on ethical bases; capitalism needs a better reformulation of its ethics and narrative. The spread of capitalism’s rotten version, the so-called “crony-capitalism,” has helped to create the wrong view of what capitalism is really about. Our new crony-capitalist system is based on short-term, profit-seeking, greedy businessmen who pursue political connections and government benefits to seize wealth, while stealing value from the American consumer. This form of “entrepreneurship” is a zero-sum game which is totally unfair and immoral. Unfortunately people see cronyism as our new established form of capitalism, hence the widespread reluctance to support the capitalist system. Following this argument, the also book stresses the fact that businesspeople recognize the profit motive as the only motive of businesses, gives them the losing ethical ground; the reality is instead quite different. People start businesses because they want to follow their passions and dreams, innovate, bear risk and at the same time serve and improve other people’s lives; this is the real purpose of business and the winning ethical ground for capitalism.
The book’s subsequent major theme presents the more practical, managerial mental models that need to be applied in order to achieve consciousness. These models are deeply rooted in the philosophy of reciprocity as previously discussed. Specifically, the book’s mental-models are: higher purpose and core values, stakeholder integration, conscious leadership and finally conscious culture and management. All categories are inherently necessary and reinforce one another when businesses seek to be conscious capitalists.
Through the mental models, Mackey reveals several real-life practices that Whole Foods has applied. They are inspired by the principles of consciousness and holistic interdependency; these principles are very much homologous to the ones imbedded in the philosophy of a free-society. These examples truly enrich the book and display how Whole Foods has added value through daily decentralize managerial decisions which have made the business successful. The misbelief that corporations need to only focus on maximizing monetary profit while neglecting communities, the health of the employees and the environment in order to succeed is drastically demystified by Whole Foods real practices. Also the misbelief that most business decisions are based on trade-offs between stakeholders is successfully challenged through seeking win-win solutions in the chain of relationships in which businesses are imbedded. Overall the book effectively challenges several other antique mental models which keep us in the “business is evil” paradigm; henceforth the book acts as a wakeup call to eliminate the old retrograde business practices in exchange for achieving greater value.
In conclusion, the term ‘conscious capitalism’ is a way of thinking about life and about doing business. It is a stand to seek a higher level of awareness of our higher purposes in life, our roles and impacts as humans and businesses and our direct and indirect relationships with other stakeholders. According to Mackey, it is “a deeper consciousness about why businesses exist and how they can create more value”. Thus it is the responsibility of ethical and conscious businesspeople and entrepreneurs to demonstrate to society their important role in the world, what businesses can do for local communities, for families and to solve deep social problems. Conscious capitalism is therefore not only a story worth telling but is a vision of our world worth preserving.
While free-enterprise capitalism is inherently virtuous and vitally necessary for democracy and prosperity, crony capitalism is intrinsically unethical and poses a grave threat to our freedom and well-being. Unfortunately, our current system has the effect of corrupting many honorable business-people, pushing them into becoming reluctant crony capitalist as a matter of survival’
John Mackey