Bernanke’s Blindness on the Great Depression

Reprinted from LewRockwell.com

With all his scholarly study of the Great Depression, Prof. Bernanke is blind to several truly major factors that caused the Great Depression. His is a blindness that he shares with very many other economists of this day and age. Their condition can be described as “a certain state of mind” that they share that prevents them from seeking out, seeing and saying what is before their eyes. And what is this state of mind? It is to defend the status quo and to stay within the comfortable bounds of conventional beliefs that support the system as it is. This spares them from confronting other institutions and their own.

Because of this state of mind, Bernanke doesn’t see or speak of the common features between the latest banking/real estate fiasco and America’s Great Depression nor, for that matter, features common to most other of America’s economic collapses and depressions. These are fractional-reserve banking, bank financing of real estate and stock speculation, and financial fraud.

By contrast, I point to Prof. Herbert D. Simpson in a 1933 article in The American Economic Review who emphasizes these very banking and real estate factors as bringing on the Great Depression. We now can see that they reappear in the recent past. (Note that my citing Simpson and other articles below means neither an endorsement of everything that the authors posit nor that our own bout of speculation follows the earlier episode precisely.)

Simpson’s article is titled “Real Estate Speculation and the Depression”. He relates that the 1920s was a period of “sensational real estate speculation”. This is a fact that he takes as given, but he merely gives an example:

“In Cook County, outside of Chicago, we had, in 1928, 151,000 improved lots and 335,000 vacant. On the basis of our Regional Plan Commission’s estimates of future population increase, it will take until 1960 to absorb the vacant lots al-ready subdivided in 1928. In fact, on the basis of these computations, we shall still have 25,000 of these vacant lots for sale in the summer of 1960. In one township, Niles Township, we have a population of 9,000, and enough vacant lots for a population of 190,000.”

In support of Simpson, the Baker Library at Harvard writes of “The Forgotten Real Estate Boom of the 1920s“, stating

“The famous stock market bubble of 1925–1929 has been closely analyzed. Less well known, and far less well documented, is the nationwide real estate bubble that began around 1921 and deflated around 1926.”

Most accounts of the 1920s mention this boom, but it has not yet influenced the thought of most modern economists. They prefer other stories, such as that of Friedman and Schwartz, which blames the FED for not inflating. Actually, it did inflate, as Gary North explains. Even though real estate is a sector of economy-wide importance, today’s economists tend to ignore its functioning because of the relative lack of data. Real estate hardly rates an entry in a macroeconomics textbook. They have been also trained to put on blinders and ignore land, ever since neoclassical economics invalidly collapsed land as a factor into capital (see Mason Gaffney for a detailed account.) Furthermore, another part of their state of mind is to think only in terms of aggregate demand, a blanket under which the real estate market and real estate speculation lie submerged and hidden.

For recent support for Simpson, there is the 2010 paper by William Goetzmann and Frank Newman titled “Securitization in the 1920’s“. The latter study backs up Simpson’s conclusion that there had been rampant real estate speculation. Goetzmann and Newman write

“The present crisis is not the first time that the real estate securities market has expanded to the brink of collapse. The U.S. real estate securities market was remarkably complex through the first few decades of the twentieth century. Many parallels with the modern market can be observed. The early real estate development industry fed the first retail appetite for real estate securities. Consequently, easily obtainable financing via public capital markets corresponded with an urban construction boom…Ultimately, the size, scope and complexity of the 1920s real estate market undermined its merits, causing a crash not unlike the one underpinning our current financial crisis.”

The mention of an “urban construction boom” by this study is what Simpson mentions in his paper 79 years earlier:

“Our latest speculative movement differs from all previous speculative eras in the United States in the fact that it has been distinctly an urban field of speculation, …”

Another recent article that compares the 1920s to the present is Eugene White’s “Lessons from the Great American Real Estate Boom and Bust of the 1920s”:

“Although long obscured by the Great Depression, the nationwide ‘bubble’ that appeared in the early 1920s and burst in 1926 was similar in magnitude to the recent real estate boom and bust. Fundamentals, including a post-war construction catch-up, low interest rates and a ‘Greenspan put,’ helped to ignite the boom in the twenties, but alternative monetary policies would have only dampened not eliminated it. Both booms were accompanied by securitization, a reduction in lending standards, and weaker supervision. Yet, the bust in the twenties, which drove up foreclosures, did not induce a collapse of the banking system. The elements absent in the 1920s were federal deposit insurance, the ‘Too Big To Fail’ doctrine, and federal policies to increase mortgages to higher risk homeowners. This comparison suggests that these factors combined to induce increased risk-taking that was crucial to the eruption of the recent and worst financial crisis since the Great Depression.”

White is correct that deposit insurance, too big to fail, and federal policies have made the present situation worse than the 1920s, other things equal.

A pervasive 1920s real estate boom or bubble is consistent with the Austrian analysis in which the banking system produces fiduciary money, lowers interest rates, and flows it into assets of long duration whose values are particularly sensitive to interest rate fluctuations.

Simpson’s analysis weaves several threads together into one fabric. The central thread is fractional-reserve banks that finance long-term assets with short-term deposits:

“Now, when it is recalled that these were not mortgage banks, organized on principles of long-term financing, investing their own capital funds, and free from deposit liabilities, but that they ordinarily purported to be commercial banks, engaged in accumulating and carrying large deposits, and that their operations were financed largely through the funds of their depositors, it will be realized in what a highly over-extended position this segment of our banking system was placed.”

Today’s banks operate on the same principle of borrowing excessively short and lending excessively long. The modern system developed an additional layer known as the shadow banking system, but it too financed excessive amounts of long-term assets with excessive amounts of short-term liabilities. This has two dangers. One is that the long-term assets fall in value by more than the value of the short-term liabilities, which means the bank is insolvent. The other is that the bank cannot roll over its short-term debts, which happens when the lenders see that the bank is insolvent. Both of these happened in both booms:

“…all the financial resources of existing banking and financial institutions were utilized to the full in financing this speculative movement. The insurance companies bought what were considered the choicer mortgages; conservative banks loaned freely on real estate mortgages; and less conservative banks and financial houses loaned on almost everything else that represented real estate in any form.”

“Eventually we reached a point where most of the city and outlying banks of the country were loaded with real estate loans or real estate liabilities of some sort. Not all of these loans were speculative; many of them were intrinsically sound and conservative. But a large, probably a major, portion of this loan structure depended for its solvency upon a continuation of the rate of absorption and turnover which had characterized the real estate market, and on a continued advance of real estate values. When the rate of absorption halted and the price movement stopped, one of the largest categories of bank collateral in the country went stale, and the banks found themselves loaded with frozen assets, which we have been trying ever since to thaw out.”

Deposit insurance paid for by banks looks as if it curtails the roll over problem, but it doesn’t. It works only in good times because the deposit insurance fund is too small to handle systemic problems. Worse yet, deposit guarantees allow and encourage banks to become larger and, with lax regulation, more overextended. The basic problem, which is holding excessive amounts of long-term assets that are financed by excessive amounts of short-term liabilities, metastasizes. This is shown by the recent problems and the unprecedented responses of the government. In the latest crisis, the federal government stepped in to guarantee money market funds, both retail and institution. It also began financing banks through the Troubled Asset Relief Program (TARP). The FDIC got involved in financing banks through the Temporary Liquidity Guarantee Program (TLGP). The FED did all sorts of financing including a Commercial Paper Funding Facility and special funding for some financial intermediaries like AIG and Bear Stearns.

Simpson’s article views the banks and their real estate financing as a major cause of the subsequent depression:

“We do not have all the facts and figures, and in the nature of things probably will never have them. But it would seem that we can safely say this much: that real estate, real estate securities, and real estate affiliations in some form have been the largest single factor in the failure of the 4,800 banks that have closed their doors during the past three years and in the ‘frozen’ condition of a large proportion of the banks whose doors are still open; and that as the facts of our banking history of the past three years come to light more and more, it becomes increasingly apparent that our banking collapse during the present depression has been largely a real estate collapse.”

A boom by definition involves an expansion. The expansion process is not what causes a boom, but it helps us to perceive the parallels between the 1920s and now to observe that the expansion process was similar in the past and present. In the real estate boom of the 1990s and 2000s, we saw not only the existing banks and institutions like Fannie Mae and Freddie Mac become more aggressive, we also saw new kinds of financial intermediaries spring up. New kinds of financing methods were also used to create mortgages, package them and distribute them to investors aggressively. These developments are not unlike those in the 1920s:

“A particularly ominous development was the expansion of the banking system itself for the specific purpose of financing real estate promotion and development. Real estate interests dominated the policies of many banks, and thousands of new banks were organized and chartered for the specific purpose of providing the credit facilities for proposed real estate promotions. The greater proportion of these were state banks and trust companies, many of them located in the outlying sections of the larger cities or in suburban regions not fully occupied by older and more established banking institutions. In the extent to which their deposits and resources were devoted to the exploitation of real estate promotions being carried on by controlling or associated interests, these banks commonly stopped short of nothing but the criminal law and sometimes not short of that.”

Simpson alludes to illegality and fraud. These too were a serious part of the 1990s and 2000s (see here).

Ben Bernanke in 1983 in The American Economic Review published “Nonmonetary Effects of the Financial Crisis in the Propagation of the Great Depression”. This paper is not intended to examine the causes of the Great Depression and it does not do so. It’s about the depression’s propagation. Bernanke points out that

“…the disruption of the financial sector by the banking and debt crises raised the real cost of intermediation between lenders and certain classes of borrowers.”

He means that the credit market slowed down to a crawl:

“Fear of runs led to large withdrawals of deposits, precautionary increases in reserve-deposit ratios, and an increased desire by banks for very liquid or rediscountable assets. These factors, plus the actual failures, forced a contraction of the banking system’s role in the intermediation of credit.”

Twenty-five years later, Bernanke was in a position in a new banking crisis to replace a new set of failed intermediaries with the Federal Reserve. In the intervening years, the non-Austrian economics profession had done nothing to focus on the causes of the banking failures and nothing to educate government officials about how to remedy those causes.

Despite not having sought or found the causes of the depression, Bernanke was not reluctant to take the position that the “financial structure” lacked “self-correcting powers”, or in other words that the free market had failed. He was far from reluctant to argue instead

“…that the federally directed financial rehabilitation – which took strong measures against the problems of both creditors and debtors – was the only major New Deal program that successfully promoted economic recovery,”

and to argue that “the government’s actions set the financial system on its way back to health.”

On what basis could Bernanke know what a healthy bank looks like without analyzing what an unhealthy bank looks like and how it got that way, namely by excessively financing real estate loans with short-term deposits flowing through the banking system due to a generous Federal Reserve? On what basis could Bernanke blame banks for being reluctant to lend when (a) they were insolvent, and (b) business was poor due to such benighted federal policies as Hoover’s efforts to keep wages high, the Smoot-Hawley Tariff, and a bevy of major New Deal programs, some of which strengthened trade unions and held wages up? On what grounds could Bernanke blithely extol government for having

“…made investments in the shares of thrift institutions, and substituted for recalcitrant private institutions in the provision of direct credit. In 1934, the government-sponsored Home Owners’ Loan Corporation made 71 percent of all mortgage loans extended.”

None of these government actions resolved the basic banking and money problems. All of them socialized finance. All of them led to new problems, including the establishment of Fannie Mae in 1938.

In 1995, Bernanke published “The Macroeconomics of the Great Depression: A Comparative Approach” in The Journal of Money, Credit and Banking. He began by saying that

“TO UNDERSTAND THE GREAT DEPRESSION is the Holy Grail of macroeconomics.”

As in his 1983 paper, however, Bernanke seals off the 1930s from the 1920s. He tells us that “finding an explanation for the worldwide economic collapse of the1930s remains a fascinating intellectual challenge,” but apparently it’s not fascinating enough to examine the effects of the real estate and stock market booms of the 1920s, or entertain the Austrian theory of malinvestment, or reference Rothbard’s America’s Great Depression, or examine the structure of banks, or think about the integration of the world economy via its banks and capital markets.

What then is Bernanke’s understanding of the Great Depression? It is

“…that monetary shocks played a major role in the Great Contraction, and that these shocks were transmitted around the world primarily through the workings of the gold standard…”

By monetary shocks, he means that the money supply contracted. We already know that this happened when the banking system became insolvent. It raises several pertinent questions that Bernanke ignores. Did the money supply grow excessively in the 1920s before it contracted, and why did the banking system become insolvent? What did they invest in and how did they finance those investments such that they eventually became insolvent? Rothbard and Benjamin M. Anderson both show that money grew rapidly in the 1920s, and as explained above so did the banks’ investments in real estate. In Economics and the Public Welfare, Anderson writes

“The purchase of approximately $500 million worth of government securities by the Federal Reserve banks…The total deposits of the member banks increased from $28,270,000,000 on March 31, 1924, to $32,457,000,000 on June 30, 1925, an increase of over $4 billion…This additional bank credit was not needed by commerce and it went preponderantly into securities: in part into direct bond purchases by the banks and in part into stock and bond collateral loans. It went also into real estate mortgages purchased by banks and in part into installment finance paper. This immense expansion of credit, added to the ordinary sources of capital, created the illusion of unlimited capital…” (pp. 127—28.)

He also writes

“There is no need whatever to be doctrinaire in objecting to the employment of bank credit for capital purposes, so long as the growth of this is kept proportionate to the growth of the industry of the country…But when in the period 1924—29 there came an extraordinary spurt of this kind of employment of bank funds, and when commercial loans began going down in the banks at the same time that the stock market loans and bank holdings of bonds were mounting rapidly, the careful observer grew alarmed. And when in addition there came a startling increase of several hundred percent in bank holdings of real estate mortgages, the thing seemed extremely ominous.” (p. 135.)

As for Bernanke’s statement about “the workings of the gold standard”, there was no traditional gold standard in the 1920s and 1930s. There was a gold-exchange standard. If a standard is to be blamed, it is the latter, not the gold standard. Murray Rothbard has explained the inflationary workings of the gold-exchange standard. Another source is The Great Depression by Lionel Robbins. Both emphasize Great Britain’s futile attempt to peg the pound at its old gold parity. Bernanke doesn’t reference either Rothbard or Robbins.

Bernanke doesn’t mention the key bank failure in 1931 that helped to propagate the depression: CREDIT-ANSTALT. The American money supply had been declining prior to this failure, and it accelerated its decline thereafter. This failure appears to have been a shock that cannot be ignored. Credit-Anstalt was the largest bank in Austria and owned about 60 percent of Austrian industry. It had grown in size due to a large but bad merger. The Austrian economy had had problems from at least 1924. Behind the scenes, a British and American consortium of banks had been secretly funneling funds to Credit-Anstalt. Its failure led to a run on the Austrian shilling. It appears that the gold-exchange standard had little or nothing to do with these events.

There are several other seeds to the Great Depression, in my view. They include the Smoot-Hawley Tariff, Hoover’s high wage policies, and other of his policies that eventually became New Deal policies. I also believe that the depression became worldwide because the economy was worldwide, as it is today, and European countries had banking and other problems that trace back to World War I and its aftermath.

On October 15, 2008, Bernanke said in a prepared speech:

“As in all past crises, at the root of the problem is a loss of confidence by investors and the public in the strength of key financial institutions and markets. The crisis will end when comprehensive responses by political and financial leaders restore that trust, bringing investors back into the market and allowing the normal business of extending credit to households and firms to resume.”

This is typical of Bernanke’s thought, which habitually stops short at asking why events occur. If he kept asking why, he might eventually get to the heart of the matter. Why has there been a loss of confidence? It didn’t just happen. What brought it about? Didn’t investors have good reason to question key banks and investment banks? Wasn’t there good reason why credit spreads had risen? Hadn’t housing prices started to drop? Those declines were real. They cannot be blamed on a loss of confidence. Why had housing prices declined? Was it perhaps because there had been a housing boom fueled by federal policies and readily available bank loans, and because prices had reached unsustainable levels? He doesn’t ask. Don’t ask, don’t tell.

Bernanke has that “certain state of mind” by which he cuts inquiry short, never going beyond the superficial because to do so would being him onto ground that to him is dangerous. He might have to condemn fractional-reserve banking, or endemic fraud in the mortgage industry, or his own institution, or lax federal regulation. So instead, Bernanke blames the Panic of 2008 on a loss of confidence in banks and markets and tries to get us to believe that the remedy is a restoration of trust.

That’s only one of his superficial explanations. The main one is the same one he thinks caused the Great Depression. He thinks that the central bank didn’t create enough money in the 1930s. The truth is almost the very opposite. Inflation of money in the 1920s worked its way through the banking system and into an unsustainable real estate boom and a stock market bubble. The problem was not too little money. It was too much. The world experienced a repetition of this high money growth between 2002 and 2008 (and before) as I have elsewhere shown. Another real estate bubble occurred. We are living in its aftermath.

Bernanke’s additions of huge amounts of base money, which are his solutions, do not solve the basic problems which are the structure of banks and the structure of fiat money.

Unfortunately, Bernanke’s blindness is not unique among today’s economists. Many of them believe the same thing. Several Federal Reserve presidents are prepared to inject even more base money into the American and world economy. There is no money supply reason for doing so, because the money supply has already soared in the last few years. There is no reason relative to the economy for doing so, because the soaring money supply has had negligible effects on economic growth and unemployment. These bankers seem to have gone Bernanke one better. He is blind, but they’ve taken complete leave of their senses.

Dr. Rozeff has published articles on stock market pricing, earnings forecasting, corporate dividend policy, corporate divestiture, insider trading, and the Asian stock markets. He has been associate editor of several finance journals. Dr. Rozeff’s recent articles on economics and politics are archived at LewRockwell.com.

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