The Fed’s Boom and Bust

Central banks were supposed to end the cycle of boom and bust, instead they amplified it
January 20, 2018 11:14 am Last Updated: January 20, 2018 12:23 pm

Politicians created the U.S. Federal Reserve system in response to the 1907 Knickerbocker Crisis, when stocks fell 50 percent over a three-week period and the financial system froze up. This new centralized system, with the Fed as the lender of last resort, was supposed to end the boom and bust cycles for good.

More than 100 years and many booms and busts later, it can safely be said that the Fed failed at preventing cataclysmic busts like the Great Depression of the 1930s or the Great Recession of 2008. But not only did it fail to prevent them, the Federal Reserve System and fractional-reserve banking—the practice of only holding reserves equal to a fraction of a bank’s liabilities—have actually caused the booms and the busts.

The Crisis All Over Again

All banking crises, before and after the foundation of the Fed, are credit crises. Banks issue unbacked credit to finance loans for investment in physical capital like mortgages and factories.

Contrary to full-reserve banking, these loans aren’t backed 100 percent by gold and are created out of nothing, providing a bad incentive for the banks to increase credit for uneconomic projects in good times and charging interest on them. Not only are the projects uneconomical—think of the subprime mortgage crisis that triggered the 2008 great recession—this incentive structure leads to rising prices and more demand in the boom phase and at the same time creates the oversupply, which will usher in the bust. Again, real estate is a good example.

All banking crises, before and after the foundation of the Fed, are credit crises.

The economic law of reflux would normally lead to depositors withdrawing their money or demanding money in gold, driving the bank out of business to punish it for overlending or lending to bad projects.

However, because the government—then as now—allows for the payment of taxes with money issued by banks, bails out banks when they are in trouble, and also guarantees depositors funds, the incentive to remove one’s money and demand payment in gold is diminished or completely removed.

A boom and bust cycle in the early 19th century saw the federal and state governments relieve banks from the duty to redeem their privately created notes in gold and gave artificial value to them by forcing the people to pay their taxes using the same notes.

Banknote circulation jumped by 87 percent from 1812 to 1816 and precious metal reserves fell by 9 percent. This was the inflationary boom.

The boom was exacerbated by another privately owned and federally-chartered bank called the Second Bank of the United States (1816), which financed the reckless lending of the many smaller banks at the end of the boom cycle, which then led to the first real depression in the young United States.

“Starting in July 1818, the government and the BUS [Bank of the United States] began to see what dire straits they were in; the enormous inflation of money and credit, aggravated by the massive fraud, had put the BUS in danger of going under and illegally failing to maintain [precious metal] payments. Over the next year, the BUS began a series of enormous contractions, forced curtailments of loans, contractions of credit in the south and west. … The contraction of money and credit swiftly brought the United States its first widespread economic and financial depression. The first nationwide ‘boom-bust’ cycle had arrived in the United States. … The result of this contraction was a rash of defaults, bankruptcies of business and manufacturers, and a liquidation of unsound investments during the boom,” writes Murray Rothbard in “Mystery of Banking.”

The centralization of banking and interest rate management in the hands of a few people at the Fed did not improve this incentive system but instead amplified faulty incentives.

A History of Crises

All of this was supposed to get better with the Federal Reserve System, which started operating in 1914. However, because the system applies the same principles that led to a credit boom, the results could only be the same.

Not only could the Fed print money without gold backing, its member banks issue even more loans using only a little bit of the Fed notes as reserves.

Headline of a Dec. 24, 1913, newspaper stating the passing of the Federal Reserve Act. The Fed was supposed to end the boom and bust cycle; instead, it amplified it. (PUBLIC DOMAIN)

The federal government also made the Federal Reserve note legal tender providing artificial demand for the printed notes. Then as now, both the states and the federal government accept payment in taxes only in money issued by private banks.

Because the anchor to gold was weakened and completely removed in 1971, the century of the Fed has been a century of financial crises.

The Fed financed the World War I boom of the second decade of the 20th century only to cause the “Forgotten Depression” of the early 1920s by tightening credit after the war.

After this recession was over, the Fed loosened policy leading to the credit bubble of the 1920s. Then in August 1928 the Fed reversed its policy of expansion, sold its Treasury bonds, and hiked interest rates. This caused money to contract and ushered in the Great Depression.

Compared to the Great Depression, the 50 percent stock market loss of the 1907 panic was a walk in the park. Stocks cratered 86.1 percent from peak to trough and the United States only finally escaped the depression because of the government spending of World War II.

Adjusted for inflation, stocks lost more than half their value in the 1970s bear market as the economy spent 2 years contracting with inflation rates soaring into double digits. The Fed and its member banks had financed the 1960s boom of government spending for guns and butter.

And only after the Fed finally declared victory over the business cycle after 25 years of only mild recessions from 1982 to 2007 did the Great Recession of 2008 remind the central planners that fractional reserve banking inevitably leads to boom and bust.

The Fed had fueled the boom and then the housing boom with record low interest rates. Banks said thank you and took advantage of government protection through the FDIC to issue trillions in bad loans for mortgages to subprime borrowers.

When the bubble finally burst, thanks to the Fed raising interest rates to 5.25 percent, the whole financial system needed to be bailed out by the Fed itself and the federal government.

Cui Bono

Given the bad incentives of the system, one wonders why we have not gotten back to a simple set up where bad actors get punished—i.e. bad banks fail—and are therefore pushed to perform better.

Maybe we find the reason in a saying commonly attributed to the powerful 19th-century banker Meyer Amschel Rothschild: “Permit me to issue and control the money of a nation, and I care not who makes its laws.”

The privately owned Federal Reserve System creates the currency and the reserves of the banking system by pressing a button. Private banks—protected by the government—issue trillions in credit money.

The contraction of money and credit swiftly brought the United States its first widespread economic and financial depression. The first nationwide ‘boombust’ cycle had arrived in the United States.
— Murray Rothbard, author, ‘Mystery of Banking’

So it’s hardly a surprise that the entities that “issue and control the money” of the United States never get punished and even profit handsomely from the boom and bust cycles.

“Power comes in many forms, but most decisive throughout the centuries is the power to advance or withdraw credit,” writes James Nolt in “International Political Economy.”

John D. Rockefeller benefited from the crash of 1929. (HULTON ARCHIVE/GETTY IMAGES)

There are “culminating points during which the economy might tip one way or the other, depending on the relative power of the bears and bulls,” just like in September of 1929 and 2008 writes Nolt.

Banks are in control at these crucial times as they can either increase or decrease credit (or money) at the turning points. They can engineer a crash but can also start a boom.

Because these insiders have knowledge in advance of the events to come, they can position themselves accordingly. Although there are winners and losers inside the banking system as well, it’s always the bigger players who profit at the expense of the smaller ones.

Too Big to Fail

In the case of the Second Bank of the United States, it was a question of whether its stockholders would take a hit or the rest of the economy would fall into recession.

“The Bank, as the largest creditor [to the state banks], had two alternatives: it could write off its debts which of course would wipe out the stockholders’ equity and result in bankruptcy, or it could force the state banks to meet their obligations which would mean the wholesale bankruptcy among state banks. There was no doubt about the choice. … The pressure placed upon state banks deflated the economy drastically, and as the money supply wilted, the country sank into severe depression,” writes Herman Krooss in “Documentary History of Banking and Currency.”

James Nolt describes how bigger Japanese companies who controlled the nation’s largest banks used their power to bankrupt and absorb smaller competitors, leading to the financial crisis of 1927:

J.P. Morgan circa 1890. The bank JPMorgan was and is a pillar of the Fed and has benefited from its status. (PICTURE POST/HULTON A HULTON ARCHIVE/GETTY IMAGES)

“One day, the big banks controlled by the Big Four cut the credit line to their fast-rising competitors and adversaries. They demanded payment; when it was not forthcoming they forced several of Japan’s largest new conglomerates into bankruptcy. The Big Four profited mightily. Since many ordinary investors panicked, not knowing which banks were exposed to the failing groups, deposits flowed out of scores of lesser banks and into the biggest banks, which were believed to be safe. Within months, these biggest banks doubled their share of Japan’s total deposits from about one-fifth to two-fifths.”

The Federal Reserve equally wasn’t shy to recommend its member banks liquidate stock holdings in February of 1929, just as it further tightened policy.  Paul Warburg, a partner with Kuhn, Loeb & Co., gave the same advice to the stockholders of his International Acceptance Bank. Sure enough, the big players like John D. Rockefeller, J.P. Morgan, Joseph P. Kennedy, Bernard Baruch, Henry Morgenthau, and Douglas Dillon, all got out in time.

The centralization of banking and interest rate management in the hands of a few people at the Fed did not improve this incentive system but instead amplified faulty incentives.

It’s important to note here that in the 1920s not all banks were members of the Federal Reserve System and many of those smaller non-member banks got absorbed by the bigger banks who had the capital to survive the crash. The larger players like JP Morgan and Kuhn, Loeb could also gobble up shares and other assets on the cheap once the liquidation was over in 1931.

This is essentially what happened in 2008. The biggest and most connected banks like JPMorgan Chase & Co., Goldman Sachs, Morgan Stanley, and Bank of America were largely unscathed thanks to a massive government bailout of the other weaker players, which the bigger banks could fairly and squarely count on. They, like Warren Buffet, knew that “Congress will do the right thing,” as he said in a CNBC interview in 2008 before the infamous Troubled Asset Relief Program was passed in October that year.

The stronger players then gobbled up smaller rivals like Bear Stearns and Merrill Lynch with the help of the government. Lehman Brothers was allowed to fail, but its good assets were sold to Nomura Holdings Inc. and Barclays of the UK.

The others like Citigroup were saved by the government with their executives keeping record bonus payments from the boom period.

The history of money and banking contains many more examples like the ones cited above. And the future will, too, until the management of money is decentralized again, the government stops creating bad incentives, and bad actors are forced to take responsibility for their actions.