The Origin of This Whole Mess: 1913

Part I

Economists disagree on the identity of the true culprit behind our current crisis. Some blame Wall Street; some blame the progressive politics that pushed Freddie Mac and Fannie Mae beyond their capacity; some blame the profiteering loan brokers, the foxy house flippers, and the naive subprime home buyers in their rush for quick profits. Some blame the Federal Reserve, including me from time to time.


[Thanks to James Montgomery Flagg, the artist, and Wikimedia.org. The image is in the public domain.]

In reality, all of the above had their role, but they are just players in a game, the rules of which are defined by politicians. The origin of the problem lies in the rule changes that caused the demise of sound commercial banking back in 1913.

Before then, good commercial banking had been functioning well, both in England and and the US, for about a century. Business cycle fluctuations, although sometimes painful, managed to keep the profession on the right track. The invention of the Fed in 1913 was supposed to allow banks to weather business cycle downturns without going completely bust because of irrational panic withdrawals that had no justification in the real data.

Morphing onto a national stage out of private banking functions already in development, the Fed's check clearing services and temporary commercial loan facilities were indeed a clever and useful idea. But the politicians discovered that, once the Fed found it could take over the centralized monopoly of legal tender issuance and then credit creation, it could be used for other things than just stabilizing the banking system. And everyone believed the Fed could control this new-found usage and that it would not do any harm.

In preparation for WWI, the government turned to the Fed credit-creation facilities to finance the war. It was a great success. The Fed managed to wrest most of the genie back into the bottle after the war by early 1920; but the temptation was too great and the discipline and privations too onerous, so they allowed over-issuance of credit to continue, ostensibly to help the country out of the recession the war disruption had caused.

The downturn ended in 1921; but the credit issuance continued. The result was 1929. As Doug Noland says in this week's article at Prudent Bear:

"It was understood at the time [during the Great Depression] that our fledgling central bank had played an activist role in fueling and prolonging the twenties boom - that presaged The Great Unwind. Along the way, this critical analysis was killed and buried without a headstone."

How true. Very few economists today remember the Fed's role in inflating credit previous to the Depression. On the contrary, everyone, from Keynes to Friedman to Bernanke, believed and continue to believe to this day that the problem lay in too little credit.

Many base their hypothesis that the Fed did not over-expand credit in the 1920s on the fact that the price level was relatively stable. Economist Edward C. Harwood pointed out in published articles that an economy can present over-expansion of the money supply even in a climate of stable prices; and furthermore, that this held true in the 1920s. Outside factors can cause real prices to fall, while an excess of money supply camouflages these factors by keeping prices at the higher level, with no one the wiser.

Furthermore, what these theorists ignore entirely is that the Fed's newly assumed power to unleash the credit genie destroyed sound commercial banking in pretty short order. ("Power tends to corrupt; absolute power corrupts absolutely." Lord Acton)

In an unpublished article written around May of 1928, Harwood described the process by which the art of commercial banking became tainted and was eventually lost. He compared it to a play in three acts. After describing the players and the events of the first two acts, he wrote:

"To date [May 1928], recent business history has paralleled acts one and two of this drama of commerce. Act III remains to be played. Just when it will begin is a problem, but it is certain that the actors will not fail to appear. It must be confessed that this drama is a tragedy. The third act may be readily imagined by those who have seen depression before. It is unfortunate that this is what we must expect, but such will always be the price of inflation."

He correctly predicted the depression that came one year later. He is one of the few, unfortunately forgotten today.

In the next parts of this blog post, I will go into the details of sound commercial banking, how it was allowed to self-destruct by the creation of the Federal Reserve, and how its destruction led to today's crisis.