Banking And The Business Cycle
A Bloomberg headline caught my attention earlier in the week: “Fisher Says Globalization Reduces Inflation Threat.” In his Tuesday speech -- “A New Perspective for Policy” -- Federal Reserve Bank of Dallas’ President, Richard W. Fisher, noted a finding from recent globalization research conducted by the Bank of International Settlements. “…[F]or some countries, including—and to my mind especially—the United States, the proxies for global slack have become more important predictors of changes in inflation than measures of domestic slack.” Mr. Fisher also noted “the realization of the importance of global economic conditions for making monetary policy decisions is becoming more widespread.” Reminiscent of the late-nineties view that extraordinary productivity gains had empowered the Greenspan Fed to let the economy (and financial markets!) run hotter, today it is “globalization” that supposedly keeps “inflation” in check, thereby bestowing the Federal Reserve and global central bankers greater latitude for accommodation.
There is great irony in the fact that U.S. led Global Credit Inflation and attendant Asset Bubbles of unprecedented dimensions are fostering (over)investment in global goods-producing capacity, a backdrop that is perceived by the New Paradigmers as ensuring ongoing “slack” and quiescent “inflation.” This is dangerously flawed analysis, and I find it at this point rather ridiculous that policymakers cling to such a narrow (“core-CPI”) view of “inflation.” I suggest Mr. Fisher, Dr. Bernanke, Dr. Poole and others read (or, perhaps, re-read) the classic, Banking and the Business Cycle – A Study of the Great Depression in the United States, by C.A. Phillips, T.F. McManus, and R.W. Nelson, 1937.
The authors brought a (refreshing) degree of invaluable clarity to complex – and pertinent - economic issues that are today simply omitted from the discourse. In particular, I much appreciate the use of the terminology “Investment Credit Inflation.” It is, after all, the creation of new financial claims (Credit) that augments purchasing power, and analysts must be vigilant observers of the sources and uses of this additional spending. The key is to recognize the nature of the Processes of Credit Creation and Dissemination, especially when marketable securities, leveraged speculation, and Asset Inflation are key facets of the boom. And just as the popular proxy index for the general price level utterly failed during the ‘twenties to indicate the prevailing massive Credit Inflation, the Fed’s favored (narrow) price level indicators today only work to palliate and mislead.
But it is better to just let the timeless insights from “Banking and the Business Cycle” “speak” for themselves.
“It is sought to show that the main cause of the dislocation in trade and industry was, in [T.E.] Gregory’s language, the ‘disregard of the rules of common sense in the treatment of the money supply’ of the United States; the depression is proximately an effect of inflation. The post [First World] War inflation in the United States was an investment credit inflation, however, as distinguished from the commodity credit inflation of War-time.” (page 4)
“The special character of the depression is traced to the hyper-elasticity of the Federal Reserve System, and to the operation of that system as exemplified in the ‘managed currency’ experiment of the Federal Reserve Board… The depression, in other words, was the price paid for the experimentation with currency management by the Federal Reserve Board…” (pages 5/6)
“Through the purchase of investments, commercial banks impart a positive upward impulsion to the business cycle. Coming in as a marginal determining factor in the price of bonds, purchases of investments by banks force down the long-term market rate of interest so that it becomes profitable, in view of the existing realized rate of return to capital at important new investment margins, to float new bond issues and to embark upon new capital development; this results in an investment boom which affects a change in the structure of production… the purchase of investments by banks creates new deposits in the banking system in much the same fashion as does the granting of loans.” (page 6)
“The term ‘inflation’ has long been the subject of interminable and diverse definition. In the view of the writers, inflation applies to a state of money, credit, and prices arising not only from excessive issues of paper money, but also from any increase in the effective supply of circulating media that outruns the rate of increase of the physical volume of production and trade, thus forcing a rise of prices… In the modern world of finance…the most important single cause of inflation is the multiplication of bank credit by the banking machinery, resulting in an increase in the volume of purchasing power…” (page 13)
“‘Lenin is said to have declared that the best way to destroy the Capitalist System was to debauch the currency [quote from Keynes].’ How close the capitalist system in America has come to destruction in consequence of the inflationary debauch of the currency indulged in during and since the [First World] War by the manufacture of deposit currency is as yet uncertain.” (page 34)
“One of the duties devolving upon economists is that of pointing out the errors in fallacious economic contentions…” (page 38)
“Overinvestment, which must be assigned the role of a positive disturbing factor, has its ultimate source in an excess of credit… the policy of overinvestment, with its attendant misapplication of capital, could never have been carried to the lengths that it was during the decade of the ‘twenties' if the banks and the Government had not supplied abundant credits at artificially cheap rates.” (page 68)
“…the position of Professor [Lionel] Robbins: ‘It may prove to be no accident that the depression in which most measures have been taken to ‘maintain consumers’ purchasing power’ is also the depression of the widest extent and most alarming proportions.’” (page 72)
“The fall in prices would in itself serve to constitute an effective check upon inordinate capital development because it would bring about a decline in the rate of return going to capital; as the rate of return to capital declined consequently upon the fall in prices the rate of accumulation of capital goods would tend to diminish. Under such conditions the system is automatically self-corrective. It is just this self-corrective process which is essential to the smooth functioning of the economic machinery. And it is in this way that the system would work were it not for the disturbing factor of credit. The injections of new credit not only permit an increase in the rate of capital accumulation, but also tend to disrupt progressively the normal equilibrium relationships between costs and prices over many sectors of the pricing front. The fundamental disequilibria are not discernable until the new credits are withdrawn or cease to increase, when it then becomes apparent that the anticipated earnings of capital based on the prevailing (artificially pegged) price level will not be realized…” (page 77)
“And for an understanding of the more immediate causes of the depression it is essential that the developments taking place in the American banking system be clearly in mind, as the changes occurring in the banking system were intimately connected with the structural changes in the economic system which led to the depression.” (page 78)
“The immediate effects of this investment credit inflation were marked by important and interrelated changes in the character of bank loans and investment assets. There developed an indirectness in the processes of bank credit financing, bank credit entering into the channels of production and trade through operations in the securities and capital markets… As a result of the plethora of bank credit and the utilization by banks of their excess reserves to swell their investment accounts, the long-term rate declined and it became increasingly profitable and popular to float new stock and bond issues. This favorable situation in the capital funds market was translated into a constructional boom of previously unheard-of dimensions; a real estate boom developed, first in Florida, but soon was transferred to the urban real estate market on a nation-wide scale; and, finally, the stock market became the recipient of the excessive credit expansion. These three booms – the constructional boom proper, the real estate booms, and the stock market hysteria – combined to produce structural changes in the economic system which were directly involved with the immediate origins of the depression. This trinity of booms contributed to sustain a seeming prosperity, the tragic speciousness of which was not widely apparent until after the bubble had burst. Hence the remote effect of the investment credit inflation was depression...” (page 81)
“The growth of deposits for all the banks in the country from June, 1921, to December 1929, was over 19 billion dollars. This is to be compared with 18.6 billion in total deposits for all banks, in June, 1914… The banking years from 1922 to 1929, then, were characterized by a great credit inflation – an absolute quantitative inflation viewed from any angle, and a relative inflation viewed with respect to the needs of trade and in consideration of the price level.” (pages 82/84)
“In the course of the time…increased flotation of corporate securities in an especially favorable capital market virtually surfeited some of the issuing corporations with liquid funds for which they found a profitable use in the stock exchange call-loan market, adding new fuel to the already raging flames of stock market speculation... Real estate bond issues were brought out on a scale unmatched in previous history… Our export trade was stimulated by extensive over-seas lending… All these factors…helped to carry business activity to the false bottom of credit inflation long enough for the term ‘New Era’ to become a byword…” (pages 112/13)
“It was through these various booms of a capital nature that the ‘cheap credit’ policy of this period found its chief outlets. The net effect of these influences was to produce an alteration in the structure of production.” (page 113)
“If the recent cycle has proved so puzzling to so many students of its devious course and manifold phases, it is because the full effects of the creation and operation of this central banking system upon the commercial banks have not been widely nor adequately understood; nor, furthermore, have the influences of the changing structure of the American banking system upon the structure of production been fully realized.” (page 140)
“Most American observers who were concerned with the structural view of business cycles were unable fully to appreciate the monetary aspects of the situation; those who were advocates of the purely monetary theory were so obsessed with the stable-price level complex that they were unable properly to assess the importance of the underlying structural phenomena which were developing… The movement of wholesale prices occupies a central role in the usual monetary theory, and this concentration of attention upon the superficial phenomena of changes in the value of money has militated against an understanding of the channels through which newly created credit entered the economic system and of the effect of this new credit upon the structure of production. Further, there are certain aspects of the recent situation which render the usual monetary theory practically useless… commodity prices as measured by the wholesale prices index in this country were remarkably stable from 1922 to 1929…so that one point definitely established by the monetary experimentation involved is that stability of the price level is a doubtful safeguard against depression.” (pages 147/148)
“In the first place, the depression was as exaggerated and as protracted as it was because the stock market crash itself was the most devastating… In the second place, the alteration of the structure of production…was greater than in any previous depression… And, in the third place, during no previous collapse was there such a complex entanglement of the banking system with the course of the depression… But underlying and supplementing all these factors was a stubbornly persisting lack of equilibrium in the entire economic and price structure.” (pages 150/151)
“It has frequently been argued that the stock market boom was justified on the basis of rapidly rising corporate earnings. Some have contended that profits not only were large in absolute amount but that they were increasing at an accelerating rate… On sober afterthought, however, it appears that the stock market boom was largely a product of bank credit expansion, a mad speculative frenzy which had no rationale whatever.” (page 155)
“Although wholesale commodity prices were relatively steady, prices in a more inclusive sense did rise. That is to say, the emissions of bank credit found expression in a rise of prices other than wholesale commodity prices, the index to which most persons are accustomed to refer when considering prices in relation to increased purchasing media. For ‘credit takes various directions, and the effects of inflation can only be measured best at those points in the business structure where the use of credit has been most active.’ The ‘points’ where credit played its most active part in affecting prices in the period from 1922 onward are those already referred to – real estate, stocks, and long-term investments.”
“…the Board’s policies also had international effects that were of far-reaching import. During the period of the ‘twenties when the United States was not only the most powerful commercial and industrial nation in the world, but also was in possession of the major portion of the stock of monetary gold of the world, our domestic developments and conditions were bound to influence the course of economic events in other countries. The [Fed] in its efforts to inflate purchasing power and to support the price level in this country helped indirectly…to arrest the decline of prices in other important commercial nations…” (page 197)
“As early as June 1927, the effects of the Federal Reserve Board’s domestic credit policies upon the international situation were diagnosed by Professor Bertil Ohlin of Stockholm University as follows: ‘The influx and efflux of gold in the United States has thus lost all influence upon the monetary purchasing power and the prices level in that country. The question of granting credit is instead determined by what the Federal Reserve Board considers suitable from an economic point of view. This implies nothing less than a revolution in the monetary system not only of the United States but of all countries with a gold standard…” (page 198)
“Stability of the price level is no adequate safeguard against depression, it is contended, because any policy aimed at stabilizing a single index is bound to set up countervailing influences elsewhere in the economic system. Although the policy of stabilization may appear to be successful for a time, eventually it will break down, because there is no way of insuring that the agencies of control will be able to make their influence felt at precisely those ‘points’ of strategic importance.” (page 200)
“A sharply contrasting objective of banking policy…and the one here advocated, would be the control of the total amount of credit, such that the violent inflations and contractions of credit would be eliminated, or at least greatly mitigated, and without special regard for any one index of economic activity.” (page 202)
The authors’ delved into considerable detail and analysis elucidating the various factors and mechanisms that supported “a much larger superstructure of credit than was previously possible.” Certainly at the top of the list was the expansion of the Federal Reserve System, along with various factors and avenues that significantly reduced bank reserve-to-deposit requirements and financial innovation generally. To be sure, however, the “hyper-elasticity of the Federal Reserve System” and the fractional-reserve banking apparatus from the ‘twenties is Inflationary Child’s Play in comparison to the virtually unchecked securities-based Credit systems of our day.
The contemporary U.S. Credit system (evolving to the status of the backbone of the global Credit mechanism) comprised of banks, the GSEs, global central bank dollar holdings, brokerage firms, the MBS and ABS marketplaces, hedge funds, finance companies, insurance companies, etc., operate today generally unrestrained from either reserve or capital requirements (not to mention a gold standard). And, in the final analysis, ‘this implies nothing less than a revolution in the monetary system not only of the United States but of all countries…’ Moreover, ‘changes occurring in the [global financial] system [are] intimately connected with the structural changes in the [global] economic system…’
“The stock market crash provided the shock to confidence which definitely and dramatically started the depression on its downward course, revealing to most persons for the first time the inherent instability of the conditions which had prevailed for several years.” (page 161)
And while “Banking and the Business Cycle” does not pursue this line of reasoning, it is my view that the 1929 crash was inevitable due to the extreme nature of speculative leveraging and deep structural maladjustment, and it was as well the impetus for an unavoidable collapse of system liquidity. One never knows from where the shock to confidence will emanate, while today’s intertwined global Credit apparatus has an unknown multitude of highly leveraged marketplaces that would qualify as potential financial dislocation catalysts. Yet one can look to today’s Highly Extraordinary Global Credit and Speculative Boom Environment and state unequivocally that the system is acutely vulnerable to any break in confidence, panicked speculator deleveraging, or even any meaningful downturn in Credit growth. Admittedly, the Global Credit Bubble has quite a head of steam. But, then again, so might global interest rates.