Updated: Oct 31
Victor Luca, 14-Apr-20.
When an uncomfortable situation emerges in our daily lives it is human nature to look back into the past for answers and guidance. This is happening now as economists and policy makers look at where we are and where we are likely to be going and begin to draw comparisons with the past. The most frequently drawn comparisons between the present day economic situation and the past is with either the Great Recession (GR, otherwise known as the Great Financial Crisis or GFC) or the Great Depression (GD). Given that the trigger for the coming economic crisis is a health crisis, I believe that we are better served looking to the GD for guidance. Of course “history never repeats, but it may rhyme”. So let’s proceed with the thesis and see where it takes us.
The Great Depression was the worst economic downturn in the history of the industrialized world, lasting from the stock market crash of 1929 through to the doorstep of the 2nd world war in 1939 (Britain declared war on Germany on 2-Sep-1939). There is general agreement that the GD was triggered by the stock market crash that started on Monday 28-Oct-1929, a date more fondly known as ‘Black Monday’. The crash came on the back of almost a decade of a massive expansion of economic activity starting from the end of the first world war (28-Jul-1914 to 11-Nov-1918) and one of the most devastating health crises in world history, the 1917-1918 pandemic known by the misnomer of the ‘Spanish Flu’. I say ‘misnomer’ because like the economic contagion associated with the crash, the Spanish Flu actually started in the presently not so united, United States of America.
It is commonly accepted that the stock market crash of 1929 was essentially precipitated by uncontrolled and reckless speculation by bankers, oligarchs, and to a much lesser extent, by just about anyone with a spare dollar in their back pocket. But mostly the blame resided with the wealthy Wall Street banking elites including the likes of Lehman Bros, Goldman Sachs, Brown Brothers Harriman and, of course, the Morgan family dynasty. Major US banks, Morgan-Stanley and JP Morgan Chase & Co, are the current-day descendants of the Morgan banking empire. These obscenely wealthy banking elites had the most money to play with. As if that wasn’t enough, these banking elites were also able to speculate with the money of ordinary folk. This was made possible because in those days the functions of commercial/retail and investment banks were combined. That is, these elites were able to use the money of ordinary Mum and Dad depositors. Let’s agree that over-exuberance and greed provided the trigger for what was to come.
As the stock market panic of Black Monday 1929 set in, and banks began to fail, investors rushed for the exits en masse and ordinary folk rushed to the banks to get their money. In other words, a good old fashioned run on banks ensued. The entire system of money and finance broke down seemingly overnight. As business confidence evaporated the downturn in spending and investment led factories and other businesses to close or reduce production and they were forced to fire workers. Foreclosures flourished and massive job losses ensued.
As a result of the bursting of the speculative bubble, people went hungry, even in a country like America, and despite the fact that there was no physical crisis affecting America’s food production capacity. Just like a global pandemic, the economic contagion quickly spread far and wide, even to other parts of the globe. The saying that “when America sneezes, everyone catches a cold” is as true today as it was back then.
America’s salvation was to come in the form of the election of democratic president Franklin Delano Roosevelt, more affectionately known as FDR. He won an overwhelming electoral victory on the 8th of November 1932 and the rest as they say is history.
What did FDR do to pull America, and hence the rest of the world, out of the great depression? Here is a summary of just a few of the measures taken by FDR and his administration. These measures were taken in a bipartisan manner, something that in the US today seems virtually impossible.
FDR started by announcing a four-day “bank holiday” during which all banks would close so that Congress could pass reform legislation and then reopen only those banks that were determined to be sound.
He also began addressing the public directly over the radio in a series of 30 talks that came to be referred to as “fireside chats”. These chats went a long way towards allaying fear and restoring public confidence because people got to know that the US Government was in their corner.
“You people must have faith; You must not be stampeded by rumors or guesses. Let us unite in banishing fear. We have provided the machinery to restore our financial system, and it is up to you to support and make it work. It is your problem, my friends, your problem no less than it is mine. Together we cannot fail.”
Aside from these comforting fireside chats, FDR embarked on reforms of the financial system, creating the Federal Deposit Insurance Corporation (FDIC) to protect depositors’ accounts and the Securities and Exchange Commission (SEC) to regulate the stock market and prevent abuses of the kind that led to the 1929 crash.
Protection of depositors’ accounts took the form of the Glass-Steagall act of 1933 which separated the activities of commercial/retail banks from those of investment banks.
In 1935, the US Congress passed the Social Security Act, which for the first time provided Americans with unemployment and disability support and pensions for old age.
Under FDR the number of African-Americans working in government tripled and women started to get a serious toe-hold in the workplace. This was probably more by necessity than by choice.
Another step taken by FDR was to increase taxation on the super wealthy, those that were mostly responsible for the obscene speculation that led to the stock market crash in the first place.
The building, or in this case, re-building of industry by a state, requires copious amounts of money and FDR also modified the monetary system to allow more money to be created. So let’s take a quick look at money.
Prior to 1933, a US Federal Reserve note looked like this:
Figure 1. US Federal Reserve note 1928 series.
At the top left corner on the front of a 1928 series US Federal Reserve note (Figure 1) of any denomination appear the following words, “Redeemable in Gold on Demand at the United States Treasury or in Gold or Lawful money at any Federal Reserve Bank”. It is impossible to over-emphasize the significance of these words. Up to about this time individual world currencies were linked to their own gold reserves.
Since gold is a relatively scarce commodity, the linking of a currency such as the USD to physical gold places natural constraints on the expansion of the money supply since you can’t create more money than the amount of gold that can be found and then economically mined. This limit in money supply seriously limits the ability of a sovereign state to stimulate economic activity.
Therefore, in 1933 the US effectively abandoned the gold standard and Americans had to turn in all their gold in exchange for paper money. Britain effectively un-pegged the pound from gold slightly earlier in 1931.
In 1944 FDR convened the famous Bretton Woods monetary conference (held at the Mount Washington Hotel), a meeting of the heads of 44 allied nations, to define the post-war economic order. A major objective of the conference was to establish the rules for world trade and stabilize world currencies. Fundamental to the latter objective was a system of fixed exchange rates with all currencies linked to the US dollar.
Bretton Woods Conference of 1944 – fixed exchange rate system intended to facilitate post war reconstruction. Under the BW system all currencies were linked to the US dollar which was allowed to float in value. Unfortunately, the system didn’t survive because the US kept running deficits to fund projects and therefore the amount of dollars in existence kept increasing while gold reserves remained constant.
Harry Dexter White (of Lithianian Jewish parents) was a pivotal Bretton Woods figure in establishing the IMF “to prevent competitive depreciation of currencies”. At the time the US controlled nearly 80% of the world gold stock.
So at Bretton Woods, White’s idea was to topple Britain as the post WWII power.
After WWII Britain was effectively insolvent, and when the world basically converged on London and said “give us our dollars and our Gold”, Britain was effectively forced into a Faustian bargain. She had no choice but to accept for the US dollar to become the basic unit of account for global trade.
As a result of the Bretton Woods conference the world got:
· The International Monetary Fund (“The Fund” or IMF).
· International Bank of Reconstruction and Development (“The Bank” or World Bank)
· A system for coordinating exchange rates (“adjustable peg”)
At Bretton Woods, all countries and citizens agreed to turn in their gold and store it in a central US location. The US dollar was linked to this store of gold and then all other currencies were linked to the US dollar. And so it was that the USD became the Reserve Currency for the world and ushered in the era of world economic domination by the United States of America.
However, this money system, for various reasons, eventually began to break down. The catalyst was the United States’ expansion of money supply due to the need to finance war.
By 1971 the US had completely severed the link between the US dollar and gold. As a result, all of today’s US Federal Reserve notes feature the statement, “This Note is Legal Tender for All Debts, Public and Private”. Again the significance of these few lines of code, cannot be understated. Money is debt and debt is money!
A new money system had been established and a new era of unfettered money creation began. Present day money is known as fiat currency. The word ‘fiat’ is Latin for, ‘let it be done’. We ended up with a money system based on faith or belief in the issuer.
Money is debt issued on behalf of a sovereign state. Whilst fiat money is a convenient medium of exchange, the overzealous creation (printing) of money can be seriously dangerous as it can result in inflation and even hyperinflation leading to the total debasement of the currency. At least 28 countries have experienced hyperinflation over the decades including Germany, Argentina, Turkey, Greece, Yugoslavia and many others.
The Nobel Prize-winning economist, Milton Friedman used to say “inflation is a purely monetary phenomenon”. Fiat money works because the users have inherent faith in it as a means of transaction.
The US Federal Reserve and any Central Bank such the Reserve Bank of NZ must take great care in the amount of money that it creates or allows to be created out of, you got it, thin air.
The mechanism by which money is created by governments and central banks is not a secret. It is given in detail in freely available documents such “Modern Money Mechanics” published by the Federal Reserve Bank of Chicago and many books. I shall not go into the details of the fractional reserve banking system here.
So it was that FDR, a Democratic president, that instilled confidence by instituting fiscally and socially responsible measures known as the ‘New Deal’, went on to rebuild a nation that had been recklessly brought to its knees. FDR ushered in an approximately fifty year period of unprecedented economic stability. In addition, the New Deal helped build the biggest middle class in world history. A middle class that made it possible for only one family member to go out and earn a living so as to buy a home and car, educate kids and take care of family nutritional and medical needs. A similar thing happened in our country at about this time.
Then in 1981, the republican president, Ronald Reagan, an actor by profession, came to power. His administration advocated tax rate reduction to spur economic growth, economic deregulation, and reduction in government spending and shifted the money creation process up a gear or two. Money creation entered a new era of exponential growth (Figure 2). Reagan’s policies represented a total about face on the New Deal that saved the US and the world from financial ruin.
Figure 2. Exponential growth of M1 money supply. Source: Trading Economics, Federal Reserve.
Concomitant with this unprecedented expansion of the money supply, now totally in the hands of governments and central and commercial banks, came other effects in terms of labor and wealth distribution.
In Figure 3 is shown how worker productivity in the US has increased since the Reagan era while real income has stagnated. More money has resulted in less money in the pockets of the average worker. The divergence in the two lines, which started at about the time Reagan came to power, continues right up to the present day. Don’t worry folks, the source of this data is as reliable as it gets, and it can probably be reproduced in many other countries.
Figure 3. Source: United States Economic Policy Institute.
Meanwhile, at about the same time in Aotearoa, the 4th Labor government of David Lange came to power and essentially applied the same recipe here in a program of copycat economic reforms known as ‘Rogernomics’. And surprise, surprise, the same recipe generated the same result as can be seen below (Figure 4).
Figure 4. Cost of Employment and productivity in New Zealand from 1978 to 2010. Adapted from Rosenberg, Real Wages and Productivity in New Zealand. https://doi.org/10.26686/lew.v0i0.1714
And guess what folks? The situation in many other developed countries is not too different because most of the world adopted the same recipe as the world leading United States of America, the so-called Neoliberal Economic Policies conjured up by the intelligentsia at Harvard Business School and other elite institutions, corporations and individuals. The US got Reaganomics, England got Thatcherism and we in New Zealand got Rogernomics, complements of non-other than the 4th Lange Labor Government.
The very political party whose name suggests should be looking after the working class ushered in an era in which the value of human labor was systematically eroded. The result was that the average hard working citizen got screwed.
It is ironic to say the least that it was a Labor government that was instrumental in reducing the value of human labor in New Zealand. As occurred during the New Deal era in America, after the GD, we too in New Zealand developed a large middle class. It was truly a golden era. A median size family required only one adult member of the family to work in order to buy a home in a reasonable time frame, buy a car, send kids to school and then maybe University, trade school or whatever. Socialized medicine took care of the family’s medical needs.
Funnily enough, those that instituted policies to make tertiary education extremely costly were those that got their tertiary education gratis. Even in this area of life we had to copy the United States of America where folks wanting a tertiary education can wind up with suffocating debt burdens from which it is difficult to escape.
Of course, these neoliberal reforms did not materialize out of thin air. In a democracy, bringing about such reforms requires some level of justification, a narrative. The Golden era was not perfect, and some reforms may well have been necessary. However, I ask folks that have been around as long as I have been whether the lives of ordinary people are better today than they were during what might be called the ‘Golden age’ from about FDR through to Reagan?
In this short article there is no space to delve more deeply into this political-economic history but suffice it to say that today in New Zealand, even before COVID-19, wealth disparity has never been higher. We have close to one million people living below the poverty line, high levels of homelessness, youth suicide stats that are the worst in the developed world and serious mental health (depressions etc), family violence and escalating drug and crime problems. A major driver of wealth disparity has been a large decrease in housing affordability. In addition to these undesirable effects, 20% of our population ostensibly experiences hunger. This is a deplorable situation in a food producing country like ours.
The neoliberal reforms have today placed us, in Aotearoa, among the group of OECD nations with highest inequality. We are positioned in the with the group of countries in the upper half of the GINI index range (Figure 5). As a result of an uneven playing field, many people have become obscenely wealthy, while many more, experience poverty.
Figure 5. Income inequality GINI coefficient, 0 = complete equality; 1 = complete inequality, 2019 or latest available Source: OECD Social and Welfare Statistics: Income distribution.
About a century after the financial fiasco of the GD, history was to repeat itself, if not in detail, then at least in character, with what came to be referred to as the ‘Great Financial Crisis’ or the Great Recession (GR) of 2008. The GR was yet again essentially another private debt-fueled financial crisis. As I said at the outset, “History never repeats but it sure does rhyme”.
As in the case of the GD, the focal point of the GR was, you guessed it, Wall Street. The first of the big private banks to fail was the abovementioned Lehman Brothers. The collapse of Lehman Brothers represented one of the most massive bankruptcies in United States history. Lehman Brothers’ and other bank failures were essentially triggered by a crisis in the housing market, itself fuel by dodgy lending practices and greed. This was in turn caused by, you guessed it, a speculative bubble fueled by the invention of fancy financial instruments, sub-prime mortgage lending (lending to folk who don’t have the capacity to repay) and the collusion of credit rating agencies. Nothing about all this was above board, or indeed moral, but few went to jail.
Lehman’s collapse was followed by the collapse of Bear Sterns and Fannie Mae and Freddie Mac (FMFM), the latter being placed into conservatorship of the government-sponsored enterprises (GSEs). FMFM however was deemed too big to fail and once again the US federal government (Uncle Sam) had to come to the rescue of private financial institutions. Apart from the above mentioned failures, another 462 somewhat less spectacular bank failures also took place during the last quarter of 2008. In addition to rescuing some of these major banking institutions, the Uncle Sam also had to bail out the likes of General Motors and Ford Motor Corporation. So in other words, socialism (the state) came to the rescue of capitalism.
The reader might be interested to know that a sovereign government can by definition never go bankrupt because it controls the creation of money out of thin air. In other words it prints its own money. The solution to the GFC was massive government intervention and, you guessed it, the massive 'printing' of money, or what is called in financial jargon, ‘Quantitative Easing’. It is not quite the same situation as during the post-WWII era of monetary expansion but has many similarities.
You can see from the graph of Figure 2 how the money supply, which started taking off in the 80s, then ramped up particularly steeply from 2008. That extra money went mostly toward bailing out banks, large corporations and businesses, and of course, re-fueling housing debt by the rescued banks.
Many argue that we never fully recovered from the 2008 crisis. A simple fact in support
of this notion is that since 2008 interest rates have been on a downward trajectory and are currently at all-time historical lows, practically zero in some places. Theory has it that the lowering of interest rates is a measure taken to stimulate a flailing economy. Since interest rates are already about as low as they can get, and since our economy has been floundering for some time, the Governor of the RBNZ was mid last year toying with the idea of so-called ‘helicopter money’. That is, the government would simply give money away as if it was being thrown out of a helicopter. Drastic measures don’t you think?
In the midst of our already flagging economy, we have recently been hit by a global pandemic that scientists and other folk have been warning us about for decades. More recently, in about 2014, Barack Obama was sounding the alarm and promoting preparedness. Instead, Trump, and his corrupt administration, systematically financially undermined the very agencies that would be needed in such a crisis and embarked on roll-backs of hundreds of environmental regulations.
Now the Pandemic in the form of COVID-19 has arrived, and countermeasures of social isolation have been applied world-wide. To avert a repeat of the 1918 pandemic, economic activity has been forced to slow significantly in the interest of saving lives. Assuming that the current pandemic is not followed up by a war, it will undoubtedly provide the trigger for a financial crisis that could in some places exceed even the GD.
Once again, sovereign states, the ultimate operators of money machines, will have to step in and throw money around like there is no tomorrow in order to help save failing business and maintain employment. One has to ask, why if our economy is so great are there so many businesses on a knife edge that they cannot even survive a month without income? Let’s park that one for now.
My point is that, once again, as in the case of the GD, which came on the heels of a world war and a pandemic followed by over-exuberance and a speculative bubble, the solution might once again be that The State comes to the rescue with its money printing machine. An alternative would be to borrow money (say USD) and finance the recovery with debt which then has to be paid back at albeit very low rates of interest.
This economic crisis will have been triggered by COVID-19, but it will be exacerbated by the buildup of yet another bubble in personal and housing debt and stagnating incomes which in real terms have been declining as they were during the 1930s.
Just as we papered over previous economic crises, so too we can, and maybe must, paper over this one, albeit temporarily, as always. If nothing else, history has taught us that monetary systems, like empires, are not forever. At some point some sort of shock triggers their failure and they have to be re-invented. Whether our present monetary system is up to the present crisis remains to be seen. Our present economic and monetary systems are predicated on the possibility of perpetual exponential economic growth in a world in which real resources are finite. Looking through the lens of Modern Monetary Theory (MMT) we seem to have two basic roads that we can take, money printing and/or sovereign debt. MMT can be considered a theory for explaining the monetary system that we currently have. Which ever way you slice it, we are talking debt because money is debt!
Whichever of these two roads is taken, debt financing in foreign currency or printing sovereign currency, the elixir may be only temporary as it has always been. One thing is for sure, never before have we expanded the money supply with the fervor of the recent times. If the money that is created is put to good purpose, and the inflation gene is kept in the bottle, then I am hopeful that the present experiment in monetary and fiscal policy will turn out well. If we get it wrong, then we risk inflicting untold harm on future generations and that would be a tragedy.
And supposing that we are lucky enough to squirm out of yet another health and economic crisis, science is telling us that the Mother of all environmental crises is just around the corner. This will be one for which human history provides no precedent. I am of course, talking about climate change.
Maybe now is the time to be bold and creative and change the paradigm to one that puts the real value where it belongs, on Mother Earth and the people that depend on her. We need to create the money to tackle the most important social and environmental issues of our time and that money needs to be distributed in a more equitable manner than has occurred so far.
Further Reading & Listening
Joshn Ryan-Collins, Tony Greenham, Richard Werner, Andrew Jackson
Where does money come from? Guide to the UK monetary and banking system. 2nd Ed. 2012. Creative Commons Licence.
MODERN MONEY MECHANICS - A Workbook on Bank Reserves and Deposit Expansion, Federal Reserve Bank of Chicago.