Free Essays On The Economic Crisis
Until the eve of the 1929 slump—the worst America has ever faced—things were rosy. Cars and construction thrived in the roaring 1920s, and solid jobs in both industries helped lift wages and consumption. Ford was making 9,000 of its Model T cars a day, and spending on new-build homes hit $5 billion in 1925. There were bumps along the way (1923 and 1926 saw slowdowns) but momentum was strong.
Banks looked good, too. By 1929 the combined balance-sheets of America’s 25,000 lenders stood at $60 billion. The assets they held seemed prudent: just 60% were loans, with 15% held as cash. Even the 20% made up by investment securities seemed sensible: the lion’s share of holdings were bonds, with ultra-safe government bonds making up more than half. With assets of such high quality the banks allowed the capital buffers that protected them from losses to dwindle.
But as the 1920s wore on the young Federal Reserve faced a conundrum: share prices and prices in the shops started to move in opposite directions. Markets were booming, with the shares of firms exploiting new technologies—radios, aluminium and aeroplanes—particularly popular. But few of these new outfits had any record of dividend payments, and investors piled into their shares in the hope that they would continue to increase in value. At the same time established businesses were looking weaker as consumer prices fell. For a time the puzzle—whether to raise rates to slow markets, or cut them to help the economy—paralysed the Fed. In the end the market-watchers won and the central bank raised rates in 1928.
It was a catastrophic error. The increase, from 3.5% to 5%, was too small to blunt the market rally: share prices soared until September 1929, with the Dow Jones index hitting a high of 381. But it hurt America’s flagging industries. By late summer industrial production was falling at an annualised rate of 45%. Adding to the domestic woes came bad news from abroad. In September the London Stock Exchange crashed when Clarence Hatry, a fraudulent financier, was arrested. A sell-off was coming. It was huge: over just two days, October 28th and 29th, the Dow lost close to 25%. By November 13th it was at 198, down 45% in two months.
Worse was to come. Bank failures came in waves. The first, in 1930, began with bank runs in agricultural states such as Arkansas, Illinois and Missouri. A total of 1,350 banks failed that year. Then a second wave hit Chicago, Cleveland and Philadelphia in April 1931. External pressure worsened the domestic worries. As Britain dumped the Gold Standard its exchange rate dropped, putting pressure on American exporters. There were banking panics in Austria and Germany. As public confidence evaporated, Americans again began to hoard currency. A bond-buying campaign by the Federal Reserve brought only temporary respite, because the surviving banks were in such bad shape.
This became clear in February 1933. A final panic, this time national, began to force more emergency bank holidays, with lenders in Nevada, Iowa, Louisiana and Michigan the first to shut their doors. The inland banks called in inter-bank deposits placed with New York lenders, stripping them of $760m in February 1933 alone. Naturally the city bankers turned to their new backstop, the Federal Reserve. But the unthinkable happened. On March 4th the central bank did exactly what it had been set up to prevent. It refused to lend and shut its doors. In its mission to act as a source of funds in all emergencies, the Federal Reserve had failed. A week-long bank holiday was called across the nation.
It was the blackest week in the darkest period of American finance. Regulators examined banks’ books, and more than 2,000 banks that closed that week never opened again. After this low, things started to improve. Nearly 11,000 banks had failed between 1929 and 1933, and the money supply dropped by over 30%. Unemployment, just 3.2% on the eve of the crisis, rose to more than 25%; it would not return to its previous lows until the early 1940s. It took more than 25 years for the Dow to reclaim its peak in 1929.
Reform was clearly needed. The first step was to de-risk the system. In the short term this was done through a massive injection of publicly supplied capital. The $1 billion boost—a third of the system’s existing equity—went to more than 6,000 of the remaining 14,000 banks. Future risks were to be neutralised by new legislation, the Glass-Steagall rules that separated stockmarket operations from more mundane lending and gave the Fed new powers to regulate banks whose customers used credit for investment.
A new government body was set up to deal with bank runs once and for all: the Federal Deposit Insurance Commission (FDIC), established on January 1st 1934. By protecting $2,500 of deposits per customer it aimed to reduce the costs of bank failure. Limiting depositor losses would protect income, the money supply and buying power. And because depositors could trust the FDIC, they would not queue up at banks at the slightest financial wobble.
In a way, it worked brilliantly. Banks quickly started advertising the fact that they were FDIC insured, and customers came to see deposits as risk-free. For 70 years, bank runs became a thing of the past. Banks were able to reduce costly liquidity and equity buffers, which fell year on year. An inefficient system of self-insurance fell away, replaced by low-cost risk-sharing, with central banks and deposit insurance as the backstop.
Yet this was not at all what Hamilton had hoped for. He wanted a financial system that made government more stable, and banks and markets that supported public debt to allow infrastructure and military spending at low rates of interest. By 1934 the opposite system had been created: it was now the state’s job to ensure that the financial system was stable, rather than vice versa. By loading risk onto the taxpayer, the evolution of finance had created a distorting subsidy at the heart of capitalism.
The recent fate of the largest banks in America and Britain shows the true cost of these subsidies. In 2008 Citigroup and RBS Group were enormous, with combined assets of nearly $6 trillion, greater than the combined GDP of the world’s 150 smallest countries. Their capital buffers were tiny. When they ran out of capital, the bail-out ran to over $100 billion. The overall cost of the banking crisis is even greater—in the form of slower growth, higher debt and poorer employment prospects that may last decades in some countries.
But the bail-outs were not a mistake: letting banks of this size fail would have been even more costly. The problem is not what the state does, but that its hand is forced. Knowing that governments must bail out banks means parts of finance have become a one-way bet. Banks’ debt is a prime example. The IMF recently estimated that the world’s largest banks benefited from implicit government subsidies worth a total of $630 billion in the year 2011-12. This makes debt cheap, and promotes leverage. In America, meanwhile, there are proposals for the government to act as a backstop for the mortgage market, covering 90% of losses in a crisis. Again, this pins risk on the public purse. It is the same old pattern.
To solve this problem means putting risk back into the private sector. That will require tough choices. Removing the subsidies banks enjoy will make their debt more expensive, meaning equity holders will lose out on dividends and the cost of credit could rise. Cutting excessive deposit insurance means credulous investors who put their nest-eggs into dodgy banks could see big losses.
As regulators implement a new round of reforms in the wake of the latest crisis, they have an opportunity to reverse the trend towards ever-greater entrenchment of the state’s role in finance. But weaning the industry off government support will not be easy. As the stories of these crises show, hundreds of years of financial history have been pushing in the other direction.
Stimulus or laissez-faire? That's the essential debate about what to about financial crisis in our time. It was the same in the 1930s.
In this world before and after the Great Depression, there was a lone voice for sanity and freedom: Ludwig von Mises. He speaks in The Causes of the Economic Crisis, a collection of newly in print essays by Mises that have been very hard to come by, and are published for the first time in this format.
Here we have the evidence that the master economist foresaw and warned against the breakdown of the German mark, as well as the market crash of 1929 and the depression that followed.
He presents his business cycle theory in its most elaborate form, applies it to the prevailing conditions, and discusses the policies that governments undertake that make recessions worse. He recommends a path for monetary reform that would eliminate business cycles and provide the basis for a sustainable prosperity.
In foreseeing the interwar economic breakdown, Mises was nearly alone among his contemporaries. In 1923, he warned that central banks will not "stabilize" money; they will distort credit markets and generate booms and busts. In 1928, he departed dramatically from the judgment of his contemporaries and sounded an alarm: "every boom must one day come to an end."
Then after the Great Depression hit, he wrote again in 1931. His essay was called: "The Causes of the Economic Crisis." And the essays kept coming, in 1933 and 1946, each explaining that the business cycle results from central-bank generated loose money and cheap credit, and that the cycle can only be made worse by intervention.
Credit expansion cannot increase the supply of real goods. It merely brings about a rearrangement. It diverts capital investment away from the course prescribed by the state of economic wealth and market conditions. It causes production to pursue paths which it would not follow unless the economy were to acquire an increase in material goods. As a result, the upswing lacks a solid base. It is not real prosperity. It is illusory prosperity. It did not develop from an increase in economic wealth. Rather, it arose because the credit expansion created the illusion of such an increase. Sooner or later it must become apparent that this economic situation is built on sand.
Did the world listen? The German-speaking world knew his essays well, and he was considered a prophet, until the Nazis came to power and wiped out his legacy. In England, his student F.A. Hayek made the Austrian theory a presence in academic life.
In the popular mind, the media, and politics, however, it was Keynes who held sway, with his claim that the depression was the fault of the market, and that it can only be solved through government planning.
Just at the time he wanted to be fighting, Mises had to leave Austria, forced out by political events and the rising of the Nazis. He wrote from Geneva, his writings accessible to too few people. They were never translated into English until after his death. Even then, they were not circulated widely.
The sad result is that Mises is not given the credit he deserves for having warned about the coming depression, and having seen the solution. His writings were prolific and profound, but they were swallowed up in the rise of the total state and total war.
But today, we hear him speak again in this book.
Bettina B. Greaves did the translations. It is her view that in the essays, Mises provides the clearest explanation of the Great Depression ever written. Indeed, he is crystal clear: precise, patient, and thorough. It makes for a gripping read, especially given that we face many of the same problems today.
This book refutes the socialists and Keynesian, as well as anyone who believes that the printing press can provide a way out of trouble. Mises shows who was responsible for driving the world into economic calamity. It was the inevitable effects of the government's monopoly over money and banking.
Just as in his attack on socialism, here he was brilliant and brave and prescient. Mises was there, before and after. He was writing about contemporary events. He issued the warnings that the world did not heed, the warnings we must heed today.
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