by
Michael S. Rozeff

Recently
by Michael S. Rozeff: Lunatic
Sorcery

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.

August
24, 2012

Michael
S. Rozeff [send him mail]
is a retired Professor of Finance living in East Amherst, New York.
He is the author of the free e-book Essays
on American Empire: Liberty vs. Domination and the free e-book
The U.S. Constitution
and Money: Corruption and Decline.

Copyright
© 2012 by LewRockwell.com. Permission to reprint in whole or in
part is gladly granted, provided full credit is given.

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