Politics not Monetary Policy Rules

John Maynard Keynes, a gifted English mathematician (not either an economist or a political philosopher), developed a comprehensive set of theories during the early stages of the Great Depression that were published in his 1935 book titled The General Theory of Employment Interest, and Money. Keynes developed his theories in an attempt to explain why we had the Great Depression and how he thought we could get out of it and further to prevent like contractions from happening again. His theories of an active federal government and government spending from taxed or borrowed money are the bases that our government is using today in an attempt at getting us out of the jobs predicament that we have now which is very much like the situation that existed in the mid 1930s.

The General Theory was designed by Keynes to replace Laissez-faire (minimum government) economics as first promoted by Adam Smith in his 1776 book An Inquiry into the Nature and the Causes of the Wealth of Nations. Which was actually a follow on book to his first book The Theory of Moral Sentiments published in 1759; the two books fit well together and should be taken and studied as a set. Smith’s free market is the exact opposite of Keynes’ views that included that savings were bad and that an active government should borrow money to spend during a down turn and then (maybe) pay it off on the upside.  Although there was some good in Keynes’ work, all the politicians back then heard was that savings were bad so that gave them the economic justification to tax wealth and even worse, if that was possible, that deficit spending was “required” to promote consumption and that by doing these things it would bring the economy to full employment Combined with the activist government concept this was a license to go wild as this justified anything the politicians wanted to do as long as it was paid for with a tax, as we recently found out with the Supreme Court ruling on the Health Care and Education Reconciliation Act 0f 2010  or Obama Care as it is now known.

In the early 30’s as the economic contraction continued to deepen, the citizens decided to try new leadership and Franklin D. Roosevelt (FDR) was elected in November 1932. However, between the times he was elected in November 1932 and took office in March 1933, the worst of the three banking contractions of the Great Depression started in January 1933. Drastic action was required and during the next two years FDR’s program was known as the New Deal which actually ended up being two programs the first New Deal (One) from 1933-1934 that was not working as planned.  Then in 1935 a second and much more controversial New Deal (Two) 1935-1938 was instituted presumably this was based on Keynes’ radical new theories which gave Roosevelt the economic justification for what he was doing and what would, in time, become known as Keynesian Economics.

Technically the programs of FDR didn’t work, but the citizens saw the government doing things and they gave the government the credit for the small recovery that occurred.  Back then just as what happens today — in politics — the politician takes all the credit for any good that occurs and blame others for all the bad. The outbreak of World War II in Europe is what really got us out of the Great Depression as the United States sold war material to the allies with Lend Lease.

Then after the war the pent up demand for civilian goods that had been repressed along with the massive rebuilding efforts of Europe’s Marshal Plan and Asia’s GARIOA is actually what drove the economy for several decades. Keynes and FDR got the credit even though the theory was wrong and FDR’s policy didn’t work. However what actually caused the banking collapse in America that started this black ball rolling was never fully understood by economists and so Keynes views took hold in the economic community; it would not be until 18 years after the end of World War II before the truth would be known.

Milton Friedman along with Anna Schwartz published an almost 900 page book in 1963 titled A Monetary History of the United States, 1867-1960 which along with other works of Friedman’s got him a Nobel Prize in Economics in 1976. Friedman and Schwartz showed how the Great Depression was caused by the actions, or more properly the inactions, of the Federal Reserve, first in allowing the credit bubble that lead to the stock market collapse in 1929 (excusable with the knowledge of the times) and then in collapsing the U.S. banking system (not excusable under any circumstances) by not following the methods that were then known for preventing this very thing from happening.  Keep in mind that preventing a monetary contraction and/or a series of banking failures was the stated main purpose for creating the Federal Reserve in 1913.  This work of theirs was the first explanation of what actually caused the Great Depression and this solved the issue which had puzzled economists for almost 30 years. This work of Friedman and later works by others, as well, showed how Keynes was wrong about savings and deficit spending. This is a very critical finding as Keynes views on economics and FDR’s policies were accepted as gospel and those policies have now taken us to the very edge of word wide economic collapse.

A side note with relevance here is that when the Federal Reserve (FED) was formed by an act of congress (HR 7837) and signed into law as Pub. L. 63-43 on December 23, 1913 a banker named Benjamin Strong Jr. one of those that developed the concept of the FED was appointed as the Governor of the New York Federal Reserve bank at that time. From its inception and until his untimely death in October 1928 he ran the New York FED which had the lead in monetary policies since most major transactions especially international were conducted in New York City where all the main U.S. banks were located.  According to Friedman’s work   Strong did everything by the book and discounting minor ups and downs up until his death the economy ran as smoothly as could be expected as a result.

Strong besides being a very knowledgeable man had a dynamic personality and others ended up in his shadow, so after his death the FED was reorganized to prevent one person from having the power that Strong had.   His successor George L. Harrison although knowledgeable did not have the personality of Strong and with the FED operating rules being changed in March 1930 he was not able to do what he knew needed to be done, so in 1930, 1931 and 1933 there were three waves of banking failures that swept across the country each worse than the preceding one.  The result was almost the total destruction of the United States banking system and the Great Depression.  Friedman states that if Strong had lived only a few more years, he died at 55, and if he had done what he had been doing while he was the Governor of the New York Federal Reserve that the Great Depression and all it destroyed would probably never have happened. Friedman did more than state that as his opinion he showed in detail how the polices of the FED and the tools they had available to them were more than sufficient to accomplish the task of preventing the banking collapses which were the real cause of the Great Depression not the stock market collapse in 1929.

But the biggest kicker was that before the FED was established to prevent banking collapses the New York banks had come up with a method to stop these contractions on their own, and that it was used on one occasion in particular a market contraction in 1907,.  Although the method wasn’t handled perfectly the logic within it was sound. The creation of the FED stopped banks individually from doing what needed to be done and established the FED as the only agency responsible for preventing banking contractions. The policies that should have been used were well known and had been used before so there was really no excuse for the FED to not allow Governor Harrison to do what he wanted to do.  It was only the FED boards’ members not wanting Harrison to follow in Strong’s footsteps that created the Great Depression.  Sadly this is what big government always gets you ‘politics’ not what really needs to be done.

But now back to our current problems; the FED is at it again with its easy money programs and massive Quantitative Easing (QE) programs. Technically what they are doing is what needed to be done in 1930 and since it was known and not used there was no excuse for what the FED allowed to happen. But as in most things there is also to much of a good thing and since the FED is more driven by politics than sound monetary policy the QE programs have been carried out way to long and that has created some serious distortions in the economy and is one of the reasons that job growth has been so anemic. The eventual result of the current FED policies will be high inflation and all we can hope for now is that it doesn’t cause us to lose the “Reserve” currency status we now have.  If that would happen we would have “hyper” Inflation and that would bring economic destruction like never experienced in this country before.

The purpose of this post was to inform the readers of what “might” happen and that they should watch current events very closely so they can protect their assets. The current softening in the emerging economies and the resulting downward trend in the markets could be a sign that currency problems are now developing.