Lessons from the Great Depression: Monetary Policy and the Federal Reserve System (Part 2 of 4)

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12 MIN READ –  The Cautious Optimism Correspondent for Economic Affairs and Other Egghead Stuff thanks Professor Jeffrey Rodgers Hummel of San Jose State University for his assistance in detailing the precise anatomy of the 1929-1933 U.S. monetary base and its surprisingly hard-to-nail-down components.

The story of the Federal Reserve’s policy blunders of 1929-1933 is one of the most complex analyses in this series of Great Depression columns requiring multiple, interdependent installments. To review prerequisite Part 1 of this series go to:

https://www.facebook.com/CautiousOptimism63/posts/992434847633348

Monetary economists of all schools overwhelmingly blame Federal Reserve inaction and even counterproductive action as the single largest factor contributing to the Great Depression. Of the Fed’s five primary functions (monopoly issuer of paper currency, member bank clearinghouse, bank regulator, lender of last resort, and administrator of monetary policy) we’ll examine the first of two that the central bank was entrusted with to fight contractionary monetary forces: monetary policy.

IV. THE MONETARY BASE

The Fed’s maintenance and support of the monetary base is a very complex mechanism to describe. To understand the Fed’s role and where it succeeded and failed, it’s helpful to define what the monetary base was in the early 1930’s and how changes in the monetary base impacted bank credit and overall price movements in the economy.

In the early 1930’s the United States monetary system operated under both a gold coin and bullion standard and fractional reserves. This made it much like other industrialized countries except that Great Britain and Europe had adopted a hybrid gold-paper standard that treated the paper pound sterling as a gold reserve substitute (the disastrous gold-exchange standard).

How did the U.S. gold standard and fractional reserves work?

For centuries prior gold had been mined and coined as a basic and trusted unit of money, then deposited at commercial banks in exchange for more convenient banknotes that served as on-demand claims for gold coins. Private banknotes then circulated throughout the economy but a noteholder could submit the note at the bank of issuance at any time to demand immediate gold coin redemption.

Since banknotes were more convenient to use than gold coins, it was rare that large sums of banknotes were returned to their issuing bank for redemption at the same time. Thus banks began the practice of “fractional reserve banking.” That is, they would print and lend out quantities of banknotes above and beyond just the notes they had already issued to the original depositor.

For example, if a customer deposited $100 in gold coins at Bank A (approximately five ounces in the 19th century), he received $100 in banknotes and Bank A held the gold coins as a reserve against its $100 banknote liability. Assuming no other changes the bank then operated on a 100% reserve.

However banks are in the business of lending at interest for a profit, so if Bank A chose to operate on only a 10% reserve, it could print up $90 more in notes and lend them to a borrowing customer. Once that customer spent the new money and the banknotes found their way to be deposited at competing Bank B, the notes would be submitted through a clearinghouse system to its original issuer Bank A, and $90 in gold coins would transfer from Bank A to redeeming Bank B. Thus original Bank A would still have its original depositors’ first $100 in banknotes circulating and the new $90 in banknotes would be retired, but it would only have $10 in gold coin remaining to back its remaining $100 banknote liability—hence a 10% reserve.

Assuming we maintain the hypothetical 10% fractional reserve, this process repeats from bank to bank and the entire monetary system could produce up to ten times the amount of paper claims that it had available in physical reserves.

For the record, on the eve of the Great Depression legal reserve ratio requirements in the United States were 13% for large central reserve city banks, 10% for mid-size city reserve banks, and 7% for country banks (source: St Louis Federal Reserve).

This process, known as fractional reserve banking, is controversial in some circles, but without going into detail to explain the theory and history of fractional reserve banking in greater detail, banks have historically been very good at managing their claims-to-reserve ratios and whenever an unmanageable quantity of redemption claims has appeared at once there has nearly always been a panic or crisis underway. However, lightly regulated systems such as Canada’s (1817-1935) and Scotland’s (1716-1845) experienced zero systemic crises and fractional reserves never posed much of a problem.

As the second half of the 19th century progressed, demand deposits (aka checkbook money) began to command a greater share of the “paper money” market. Simple ledger entries in bank accounting statements indicating customer deposit balances proved more convenient than banknotes, and large commercial transactions were conducted increasingly using checkwriting. However the general principle remained the same: both demand deposit balances and banknotes were direct claims on gold coin and banks had to manage the amount of each they created through their lending practices.

When the Federal Reserve was established in 1914, commercial banks sent most of their physical gold to the Fed where it was melted down into bullion to centralize what were previously divided and fragmented reserves that could not move easily between banks or across state lines. Now with such a large concentration of gold at its disposal, the Fed would issue its own banknotes, paper reserves, or credit to member banks in need of new reserves for commercial lending purposes or for temporary liquidity.

This is a key change with the introduction of the Federal Reserve system worth stressing.

Whereas before commercial banks redeemed their own banknotes and demand deposits into gold coin, under the new system the banks no longer issued private banknotes. Instead they redeemed their demand deposits into Federal Reserve banknotes (the Fed was granted a monopoly on banknote issuance by the 1920’s) and Federal Reserve banknotes were themselves redeemable into gold coin.

So the fractional reserve system was expanded from two layers to three. At the base was mostly Fed gold (1), in the next layer were Fed issued paper currency and Federal Reserve deposits (both reserves) for member banks (2), and at the top were member bank-created demand deposit balances fractionally backed by paper currency and Federal Reserve deposits (3).

The Fed printed up banknotes or created new commercial bank reserves against its own gold reserves on a fractional reserve: namely 40%. To inject the new notes or reserves into the banking system it typically bought assets such as short-term commercial loans from banks using newly printed Fed notes or by making a ledger entry in its own books indicating the member bank had a higher reserve balance with the Fed itself (Federal Reserve deposits)—provided the Fed did not extend the quantity of these instruments beyond 250% of its gold reserves, the inverse of a 40% reserve ratio.

Which brings us to the definition of monetary aggregates. What economists refer to today as the monetary base is the portion of the money supply that the central bank has a great degree of control over. In the 1930’s that was

-Fed notes (a multiple of gold reserves)

-Federal Reserve deposits it provided to commercial banks  (a multiple of gold reserves)

and to a much smaller degree...

-gold coins held outside the Fed/Treasury

-Treasury-issued gold certificates held outside the Fed/Treasury

Or in other words, the early 1930’s monetary base (MBASE) = any Fed notes + Federal Reserve deposits + gold coins + Treasury gold certificates held outside the Fed system or the Treasury.

Since gold coins and Treasury certificates were relatively small, the monetary base can be simplified down to primarily Fed notes and Federal Reserve deposits for the purpose of this discussion—both then treated as reserves by commercial banks.

Once a commercial bank knew what its own reserves were it could lend out demand deposits or checkbook money on its own fractional reserve. The total amount of commercial bank demand deposits and Federal Reserve notes circulating in public hands was and remains known as the M1 aggregate. M1 has always been larger than the monetary base.

There was and still is another aggregate layer atop M1 called M2 which represents monetary instruments that are claims on M1 checkbook money—typically time deposits, savings deposits, and in the modern age money market shares and certificates of deposit under $100,000. For the purpose of the 1930’s we will temporarily exclude M2 from the policy discussion since much of that aggregate is not very liquid and had a far smaller impact on the financial system than M1.

So the Fed had a great deal of control over the amount of bank reserves and Fed notes, and less control over gold reserves (coin and bullion) as it was always subject to gold redemption claims and gold inflows/outflows via international balance of payments.

The commercial banks had a much greater degree of control over the larger M1 aggregate just as they do today, since M1 is largely dependent on banks’ willingness to lend and bank customers’ willingness to borrow.

V. FED POLICY RESPONSE: THE MONETARY BASE

Now that we’ve defined the fundamentals of the monetary base and M1, what happened to both during the Great Depression and how did the Fed react?

Well as is the case with most depressions, particularly those accompanied by banking panics, both aggregates fell. Borrowers got nervous and began paying down debts which reduced M1. Banks were reluctant to lend and their customers just as reluctant to take on new debt which prevented M1 from reflating.

If banks fail completely there’s a larger contractionary effect on M1 because all its demand deposit promises become worthless (its checks are viewed as “no longer good”). M1 balances being wiped out due to bank failures is the basis of the commonly told story about bank customers losing their life savings during the 1930’s.

When customers rushed to withdraw Fed notes, M1 contracted because banks were required to maintain a certain reserve ratio backing their demand deposit balances. With fewer Fed note reserves, they couldn't lend as much and often called in loans to maintain that ratio. In other words, the banks' reserves contracted therefore so did their demand deposits.

At an even more fundamental level if holders of Fed notes began redeeming them for gold and pulling gold coins out of the banking system, M1 also contracted since gold coins were part of the monetary base that served as a reserve backing demand deposits. If large holders (such as foreign central banks) started redeeming gold bullion, the monetary base itself contracted since bullion was the 40% reserve upon which the Fed backed the majority of the monetary base—Fed notes and commercial bank deposits at the Fed. Since M1 is a multiple of the monetary base it contracted in parallel.

All of these problems materialized during the Great Depression, just as they had during previous banking panics, although their nature and degree varied from the panics of 1930, 1931, and 1933. It was the young Federal Reserve’s job to counteract these forces, a role it was created to carry out from its inception.

Which leads us to a debated and slightly controversial claim about a Fed failure: that the Federal Reserve not only oversaw a contraction of the monetary base from 1929-1933, but that it deliberately contracted it. This claim is made by some within the mainstream economics community, propagated by some members of the Keynesian school.

The truth as we shall see is that the Fed indeed didn’t do all it could to expand the monetary base, but the claim that the monetary base was deliberately contracted or contracted at all is technically inaccurate. From the October 1929 stock market crash to the final banking panic of March 1933, the monetary base actually rose slightly from $6.122 billion to $7.032 billion (source: FRED).

https://fred.stlouisfed.org/series/AMBNS

So why is the Fed still so criticized for not doing enough?

Well it’s a perfectly valid criticism. One thing that is missing so far from the story that Friedman and Schwartz highlighted is gold inflows. During the early 1930’s the United States was running surpluses with its trading partners and therefore claimed overseas gold which flowed into the Federal Reserve system.

Also many European governments continued to make debt repayments to American banks and investors for financing their World War I expenditures. Furthermore, when Britain went off gold in 1931 the Fed responded by raising interest rates to “defend the dollar” which in turn stemmed some of the gold outflows and actually attracted sizable inflows of international gold back to the U.S.

What the Fed is roundly and rightfully criticized for is refusing to create new bank reserves against those gold inflows—effectively “sterilizing” the gold which can be viewed as putting it in under lockdown. So as new gold arrived it wasn’t “monetized,” and new reserves that could have been provided to counter the forces of cash withdrawals and gold redemptions went uncreated.

A little known fact is that even with all the domestic and foreign withdrawals of gold from the banking system, the Fed’s own gold reserves were actually higher at the end of 1932 than during the 1929 stock market crash ($3.15 billion vs $2.95 billion, source: St Louis Federal Reserve). And even as the final panic struck in March 1933 Fed gold reserves were even slightly higher at $3.25 billion.

Indeed by the time of the final and most devastating banking panic of 1933, the Federal Reserve System held 40% of the world’s entire gold reserves—a point not lost on the incoming Roosevelt administration's new Brain Trust.

Under the pre-WWI classical gold standard, gold inflows would have been multiplied by the decentralized banking system and both stabilized the banks' reserves and reinflated prices. But the 1920's and 1930's were an era where central banks ran the show, not the automatic mechanisms of the classical gold standard, and the Federal Reserve "broke the rules" of the game.

Why did the Fed sterilize gold inflows? This leads us to the second as yet unmentioned Fed policy problem.

VI. FED INACTION AND THE REAL BILLS DOCTRINE

From its inception, the Fed was officially governed by the now discredited “Real Bills” doctrine of monetary policy. Real Bills was written into the 1913 Federal Reserve Act itself, but largely ignored under the leadership of New York Fed Governor Benjamin Strong.

The Real Bills Doctrine defined a solvent bank as one that held a large quantity of commercial loans to businesses and on very short terms. The idea was not only that newly created central bank reserves could be rapidly repaid by banks when their short-term commercial paper liquidated, but also short-term commercial lending was viewed as an “appropriate” means of conducting banking business.

The Real Bills Doctrine was also justified on anti-inflationary grounds. The thinking was that the Fed should not create inflationary reserves unless the receiving bank is involved in some activity that increases the real quantity of goods and services in the economy. With new money creation consummated with new production, inflation would remain tightly controlled. Or to put it another way, the direction of Fed monetary policy should align closely with the overall direction of the real economy.

This may seem counterintuitive to those of us in the modern era who watch the Fed conduct countercyclical monetary policy—to slow down money creation when the economy grows quickly and accelerate money creation when the economy slows—but Real Bills was the governing doctrine for Fed leadership after Benjamin Strong’s died in 1928.

During the early 1930’s many banks were suffering the overhang of lending for stock market and real estate speculation. Of those that had loaned for tangible business purposes and held short-term commercial paper, many seeked out new reserves, but only to replace those reserves they were losing due to customer cash withdrawals—not to lend out for economic-expansionary reasons. Thus the Fed considered both types of institutions ineligible for new reserves and much of its gold inflows remained dormant and sterilized.

To put the perverseness of this policy into perspective, consider that during the Panic of 1930 most troubled banks were in the Midwest farming regions. Most of those banks had made farm loans which are typically of longer duration than short-term commercial paper.

Yet according to Real Bills Doctrine a bank holding longer-term farm loans was not considered “solvent” and thus its assets could not be discounted (sold to the Fed for reserves minus a discount for time the Fed must wait before the paper matures). So the Fed sat on its hands and 608 midwestern banks failed (Friedman, Schwartz).

To be fair, many of those banks were not Federal Reserve members, and 608 mostly smaller, rural bank failures may not seem earthshattering in the scheme of America’s then 25,000+ banks. But when a larger panic struck in 1931 Fed officials adopted the same stance. This time 2,293 banks failed and many were Fed members. 1,493 more banks failed in 1932 and more than 4,000 failed in the great 1933 panic.

By the time the Banking Act of 1935 mandated the Federal Reserve discount any security it deemed necessary to maintain monetary stability, over 11,000 of America’s more than 25,000 banks had closed their doors for good.

Ironically the Fed’s belief that creation or destruction of reserves should move in tandem with economic growth became a self-fulfilling prophecy. According to the tenets of the Real Bills Doctrine, 1930’s Fed officials saw the quantity of goods and services in the real economy contracting, so they responded accordingly by refusing to make new reserves available. The result was bank failures and a contraction of the money supply (ie. a financial disaster) which led to further economic contraction. But it all conformed with the doctrines of Fed policy.

Finally, Fed officials were perfectly aware that refusing to make new reserves available to stressed institutions would certainly drive many to close their doors, but they viewed such failures as a process of clearing out “bad” banks that would leave the system as a whole stronger, dominated by banks that were more aligned with Real Bills precepts. And while this may have been partially true for truly insolvent banks that had loaned unwisely during the 1920’s boom, such a mindset would prove disastrous when insolvent bank failures spread to solvent ones.

It was also a contradictory repudiation of the Fed’s most fundamental obligations to provide temporary liquidity.

We’ll discuss the Fed’s simpler but crucial lender of last resort role in Part 3.

Lessons from the Great Depression: Monetary Policy and the Federal Reserve System (Part 1 of 4)

Click here to read the original Cautious Optimism Facebook post with comments

9 MIN READ - The Cautious Optimism Correspondent for Economic Affairs and Other Egghead Stuff continues his more than year-long investigative series on the Great Depression. This time he tackles the complex subject of monetary policy and tragic errors made by the Federal Reserve.

I. INTRODUCTION

In chapters 1-6 of this Great Depression series, we’ve examined herculean blunders in federal tax, spending, wage, and agriculture policy as well as the monetary roots themselves of the Great Depression including the failed gold-exchange paper-sterling standard foisted upon Europe by Great Britain from 1925-1931.

Many of these missteps are still noted by economic historians today while economists of the more statist bent tend to downplay them as insignificant factors or more commonly omit them completely from the discussion.

However if there’s one Great Depression consensus among economists of all stripes, it’s that the single greatest American economic policy failure of the early 1930’s lies with the Federal Reserve in the banking and monetary sphere.

Initially not a well-recognized failing, Milton Friedman and Anna Schwartz brought the Federal Reserve’s blunders to the forefront of the academic discussion in their 1963 book “A Monetary History of the United States: 1867-1960.”

Friedman and Schwartz’s work instantly changed the entire Great Depression debate and future central bank policy responses, and Friedman received the 1976 Nobel Prize in Economic Sciences for his work.

Before 1963 the mainstream view was that the Fed had acted appropriately by providing adequate reserves to the banking system in the 1930’s, but that it was powerless to force commercial banks to lend out those new reserves to prevent the money supply from contracting (the so-called “pushing on a string” dilemma).

Since banks were in no mood to lend during the crises of the early 1930’s, the only other solution, according to the dominant mindset of the day, was fiscal policy—governments borrowing and spending heavily to prop up aggregate demand and entice consumers and businesses to spend the economy out of depression.

Since 1963 however both the mainstream Keynesian and Monetarist schools, and even many members of heterodox disciplines such as the Modern Monetary Theory (MMT) and Austrian School, have adopted a different stance: that the Fed either obstructed monetary re-expansion or failed to make the very emergency loans to distressed banks it was created for, and that these monetary policy failures were the single largest contributing factor in transforming what should have been the Recession of 1929 into The Great Depression.

A personal diversion/observation: The Economics Correspondent parts ways with the mainstream schools that hold the Federal Reserve nearly solely responsible for the Great Depression. Yes, the Fed’s missteps were the largest single contributing factor, but far from the only culprit. The traumas inflicted by steep government tax hikes, ballooning spending, price controls, wage floors, a deluge of burdensome new regulations, forced cartelization and price collusion programs, and the launching of an international trade war—both under the Herbert Hoover and Franklin Roosevelt administrations—were collectively greater than the Federal Reserve’s missteps alone.

To understand the magnitude and nature of the Fed’s failures, we have to go back briefly to the American banking system before 1914 and why the Fed was created to begin with.

II. AMERICA BEFORE THE FEDERAL RESERVE

In the years before the 1914 establishment of the Fed, the United States banking system was fragmented and unstable. Mainstream economists and economic historians often fail to pinpoint the origins of this instability and leave it to readers to assume the 1792-1913 period was one of monetary laissez-faire, but in fact it was a series of perverse state-level and national regulations that contributed to the banking system’s fragility.

A detailed discussion of pre-1914 bank regulations including unit banking, the 1862-1913 National Banking System, and America’s antebellum central banks—the First and Second Banks of the United States—will come in a future column. However the comparison between the American banking system and that of its northern neighbor illustrates the contrast quite well.

Canada’s very lightly regulated, nearly laissez-faire banking system also had no central bank (until 1935), and during the 1792-1935 period Canada suffered from zero banking crises. The United States banking system endured no fewer than seventeen crises during the same period in 1792, 1797, 1819, 1837, 1839, 1857, 1873, 1884, 1890, 1893, 1896, 1901, 1907, 1920, 1930, 1931, and 1933.

(Note: Some economic historians cite the Canadian Rebellions of 1837-1838, an insurrection falling just short of civil war, and the resulting widespread banking suspensions of redemption, but the Economics Correspondent has never seen that single exception elevated to the status of systemic banking crisis since only one major bank failed)

One of America’s biggest vexations during the pre-Fed era was temporary illiquidity. That is, banks accepted customer deposits that could be withdrawn on demand, but made loans that took longer—years often—to pay back, a phenomenon economists call the temporal mismatch of maturities.

Thus, even with a pristine loan portfolio worth far more than its deposit liabilities, a perfectly solvent bank could still fail if too many of its customers demanded reserves (at that time usually gold coin) at once—called a “bank run” which typically occurred within an atmosphere of financial panic. Even if a bank demanded immediate repayment of so-called “call loans,” it usually couldn’t raise enough liquid funds to satisfy panicked depositors.

Canadian banks of course had similar business practices and in theory could suffer from the same illiquidity problems, but didn’t absent the perverse regulations imposed on American banks. For example, Canadian banks weren't prohibited from branching nationally and thus enjoyed highly diversified loan portfolios, were highly capitalized, and could move capital from stable provinces to regions that were experiencing loan losses. U.S banks were prohibited by law from interstate branching.

After the Panic of 1907 the illiquidity problem in the United States had become so great that Congress recognized the need for reform. In simplest terms America could choose from two different directions: moving towards the more stable, laissez-faire Canadian system by dropping the most perverse regulations that had led to repeated panics, or retain the unstable unit banking system and create a European-style central bank that centralized the entire system’s reserves and provided emergency liquidity loans to banks to quell a crisis.

Congress set up the National Monetary Commission to discuss the options, but in reality the commission had already made up its mind before any studying began. Banking interests and state governments (who selected their U.S. Senators before the 17th Amendment) had already convinced legislators to retain most of the fragile system but place a central bank atop it to “bail out” banks that get into temporary liquidity trouble.

The political motives behind the decision are an interesting history, but to make a long political story short the Federal Reserve Act was passed on December 23, 1913 and signed into law by President Woodrow Wilson late that evening; the night before Christmas Eve, when most of the country was not watching political doings in the nation’s capital.

What were the major changes in the central bank’s new charter?

1. All paper currency would be supplied by the Fed and privately issued national banknotes phased out.

2. The Fed would provide a national clearinghouse system to resolve balance of payments and check clearing between member banks, replacing several private clearinghouse systems.

3. Most importantly, bank gold reserves would be centralized at regional Federal Reserve district offices and the Federal Reserve would stand ready to issue cash against centralized fractional gold reserves. The idea was that during times of crisis the Fed would use those centralized reserves to provide cash to its member banks in the form of a temporary liquidity loan that the bank would pay back when the crisis had abated.

If a bank was technically solvent but just suffering a drain on liquid assets, the bank would approach the Fed’s “discount window” for a loan and the Fed would step in and provide the short-term credit against good bank collateral (the definition of good collateral would pose enormous problems later). But if the bank was insolvent, if its assets fell far short of its liabilities, the Fed would allow the bank to fail.

This function, known as the “lender of last resort” (LOLR) was originally proposed by English financier Walter Bagehot in his 1873 book “Lombard Street” and its recommendation that the Bank of England lend freely to solvent banks during crises remains the policy bible of central bankers around the globe today.

Shortly after 1914 the Fed also began to act as a conduit to overseas banks, intermediary to foreign central banks, and one of America’s primary bank regulators. It also became a fiscal agent of the federal government (World War I), and engaged in macroeconomic monetary policy through open market operations (1922).

But its primary role from the very beginning, it’s raison d’etre so to speak, was to act as lender of last resort (LOLR) in times of crisis.

Prior to the Fed large commercial banks and their private clearinghouses had acted unofficially as LOLR’s but their actions were voluntary, often not well coordinated, and not nationwide (due again to unit banking and interstate branching prohibitions which limited their operational range).

The Federal Reserve replaced the disparate private system and provided a single, uniform, and national LOLR institution to help banks in temporary liquidity need. Fed architects, Congress, and President Wilson hailed a new era in American banking that would eliminate financial crises altogether and greatly smooth out the depth and frequency of business cycles.

III. THE GREAT DEPRESSION STRIKES

Beginning in July of 1927 the Federal Reserve engaged in a sizable quantitative easing to help Great Britain curb its trade deficits with the United States. The Fed’s balance sheet grew by 55% in just seventeen months and new money spilled over into stock market and real estate speculation.

To read more about the motivation behind the destabilizing Fed QE read “What Really Caused the Great Depression?” at the following Cautious Optimism links:

Part 1

http://www.cautiouseconomics.com/2018/11/the-great-depression-01.html

Part 2

http://www.cautiouseconomics.com/2018/11/the-great-depression-002.html

Part 3

http://www.cautiouseconomics.com/2018/11/the-great-depression-03.html

Upon the death of New York Fed Governor Benjamin Strong in October of 1928, the Fed promptly ended its monetary expansion in December and the economy entered recession in the summer of 1929 with the stock market collapsing famously in October of 1929.

With many bank loans tied to speculative investments and the economy in general entering depression, banks began to face rising loan losses. Particularly hard hit were banks in those areas of the country that were adversely affected by the Smoot-Hawley trade war (minerals, autos, steel, and agriculture were targets of retaliatory export tariffs).

States that prohibited intrastate branch banking also saw a larger share of loan losses and distressed institutions since state-mandated small unit banks were unable to diversify their loan portfolios.

A single unit bank in a small Iowa corn town could easily fail if the price of corn plummeted. Likewise a single unit bank on the Canadian border could be crushed by a dropoff in Canadian trade resulting from the Smoot-Hawley tariff.

On the other side of the Canadian border, banks were large and nationally branched. Therefore their loan portfolios were highly diversified which helped Canada avoid a banking panic during the same period. Indeed, not a single Canadian bank failed during the entire Great Depression.

Over the course of the 1929-1933 period three banking panics struck the United States during which depositors began to convert their checkbook balances to cash or even gold.

The first and smallest was in 1930 which was limited to the agricultural, Midwest region. In September of 1931 the Bank of England suspended gold convertibility and foreign holders of American cash and deposit balances began to withdraw gold from the U.S. system. And in February of 1933 the largest banking panic in American history struck, launched by rumors that FDR was going to devalue the dollar or worse yet go off the gold standard completely (rumors that later both turned out to be true).

In each case, smaller numbers of insolvent banks failed, but news of the failures stoked fear in the customers of nearby solvent banks and they ran for the exits. As cash started to flow out of the system, solvent banks’ balance sheets were strong enough to withstand the panic, but they simply needed the temporary liquidity that the Fed was created to provide as lender of last resort.

But the Fed didn’t act as lender of last resort. Altogether the Fed stood idly by and did nothing while solvent bank after bank failed due to lack of liquid cash to provide their customers.

And as customers withdrew cash and stuffed it under their mattresses, the system’s overall reserves contracted (Fed notes/cash being a reserve). The Fed had the capacity to issue more cash but only up to a limit: cash plus bank deposit balances at the Fed itself could not exceed 250% of the entire system’s gold reserves—a 40% fractional reserve cover ratio.

Furthermore, with foreigners pulling gold out of the United States, and in 1933 American citizens converting their Fed notes into gold, the overall gold stock upon which the entire financial system was based experienced downward pressures as well.

In Parts 2-4 of this series we’ll provide a more detailed explanation of the Fed’s policy action and inaction during the critical 1929-1933 period.

Herb Kelleher: The Man Who Democratized Air Travel

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4 MIN READ - The Cautious Optimism Correspondent for Economic Affairs and Other Egghead Stuff’s career began nearly three decades ago at a major airline that competed head-to-head with low-fare upstart Southwest Airlines. Former Chairman and CEO Herb Kelleher’s recent death has revived the story of his fight against not only entrenched competition, but heavy-handed government regulation that nearly crushed Southwest in its infancy.

Kelleher and Fort Worth-based American Airlines CEO Robert Crandall

Southwest Airlines co-founder Herb Kelleher died this week at age 87. While most Americans today are acquainted with Southwest Airlines’ no-frills and fun anything-goes service, they may be less familiar with its tumultuous beginnings. Before Southwest’s first flight left the ground it was nearly killed by endless legal challenges and restraining orders filed by incumbent competitors.

Younger Americans may not remember that when the idea for Southwest was reportedly drawn on the back of a San Antonio bar cocktail napkin in the late 1960’s the U.S. airline industry was completely regulated by the federal Civil Aeronautics Board (CAB). 

If an airline wanted to raise a fare it needed permission from the CAB. To lower a fare it waited for permission from the CAB. Adding or removing a flight had to clear with the CAB. To start service to another city or on another route it had to apply with the CAB. To end service or close a route, to change a flight schedule, to add or reduce frequency of routes in markets, to offer new in-cabin service, and yes, to start a new airline; it all had to be approved by the CAB first.

The well-established legacy carriers also fostered a nice exclusive club with their cozy CAB relationships. Cooperating with the incumbents the federal government effectively cartelized the industry and maintained very high fares with its price policing power—much the same way OPEC operates today only that, unlike OPEC, the airlines were legally required to comply with the CAB’s mandates whereas OPEC member nations can and often “cheat” with little or no consequences.

(By the way, there is plenty of precedent for this arrangement going back to the Interstate Commerce Commission's cartelization of railroads to enforce higher-than-market rates in the 1880's and FDR’s National Industrial Recovery Act that cartelized nearly every big business in America and mandated collusion to raise prices)

Some fruits of the CAB cartel include Pan Am’s famous government-granted monopoly on U.S. commercial service to Europe, the duopoly granted to Pan Am and Northwest to fly to Asia (later absorbed by United and Delta respectively), and a legacy of very high fares that confined air travel to only wealthy Americans. As Kelleher notes in the attached article “a couple of years ago [approx. 2008] 85 percent of [Americans] had flown at least one commercial flight as opposed to 15 percent in 1966."

Along came Southwest in the late 1960’s with a new idea: offer frequent, rapid turnaround, no-frills, low fare service between three Texas cities: Dallas, Houston, and San Antonio. Kelleher was the co-founding attorney who was to become Chairman and Rollin King a pilot and businessman who would be a managing director.

No sooner than Kelleher had secured financing and was ready to launch his first flight did Southwest's three primary Texas intrastate competitors—Continental, Texas International, and Braniff—file suit to ground the new airline (see attached Reason article).

https://reason.com/blog/2019/01/04/rip-herb-kelleher-the-man-who-democratiz

Southwest fought over four years of litigation battles with the CAB-connected cronies before its first plane ever wheeled up. Unable to fly and earn revenue its finances were drained by legal fees which reflected the strategy of the legacy carriers: If they couldn’t shut down Southwest completely in court, they planned to hobble and eventually bankrupt it with a long-drawn out legal battle during which they were allowed to keep flying and finance themselves but Southwest could not.

Kelleher promised Southwest’s investors he would personally incur all legal costs if they lost their Texas Supreme Court appeal. Famously (and thankfully) Southwest won, the ruling being that service between three Texas cities represented intrastate service and therefore was outside the interstate commerce domain and price-control authority of the CAB.

The rest is history. Southwest started low fare service and undercut its competitors. Braniff attempted to predatory-price Southwest out of the skies with an even lower $13 moneylosing oneway Houston-Dallas fare and Southwest responded by matching but also offering an alternative $26 fare that included a free bottle of Chivas, Crown Royal, or Smirnoff. Two months later Southwest was the largest distributor of premium liquor in Texas and the tactic worked. Braniff called off its campaign to “break” Kelleher and Southwest grew rapidly and democratized the skies—its low cost model and fun-loving culture luring customers from competitors and creating new customers who previously couldn’t afford to fly.

In another market-friendly turn of events, the CAB was dissolved as part of federal partial airline deregulation beginning in 1978 and Southwest was freed to extend its model outside of the Texas market right as it had reached its intrastate limits. After a short period of chaotic adjustment in the industry, airlines settled into their current hub-and-spoke model which, while unpopular with passengers who have to make connections, is so economically efficient that it has simultaneously expanded service to hundreds of previously unserved smaller cities, increased the frequency of flights, and reduced average airfares by nearly 60% adjusted for inflation.

While Southwest started with a point-to-point model that eschewed hubs, it quickly ran out of profitable point-to-point markets and adopted hub-and-spoke itself as anyone who has connected through Phoenix, Las Vegas, Chicago Midway, or Baltimore can attest.

Southwest and partial airline deregulation truly “democratized the skies” and air travel is considered a common everyday commodity today as opposed to the exclusive domain of the rich before 1978.

And in the end Southwest won more than just the legal battle. It’s now the largest domestic airline measured by passenger boardings, has managed an incredible streak of forty-plus years of profitability in an industry beset by bankruptcies (every other major U.S. airline filed for bankruptcy during the 2002-2011 period), has paid above average compensation in exchange for higher employee productivity, has consistently ranked among the top American companies to work for, and during a 25-year period from the early-1970’s to mid-1990’s its stock price rose by over 40,000%. 

Most ironically Southwest is still around and larger than ever while crony antagonists Continental, Braniff, and Texas International all eventually filed for bankruptcy and either ceased operations or were absorbed into other airlines. As is often the case, the firms that receive the most government protection or subsidies fail while those that operate as private, for-profit enterprises and have all the cards seemingly stacked against them succeed.

Southwest’s low-fare model has also inspired countless startup copycats in Europe and Asia, democratizing air travel for hundreds of millions more around the world.

And it all hinged on a single court ruling that placed limits on the reach of the autocratic regulatory CAB which had fostered industrywide inefficiency and cronyism, and broke the CAB-enforced cartel that tried to project government power against the little guy to prevent him from offering the consuming public his better mousetrap.

RIP Herb Kelleher (1931-2019)

This Didn't Age Well. Larry Summers: Electing Trump Will Cause a Global Recession Within 18 Months

Click here to read the original Cautious Optimism Facebook post with comments

1 MIN READ - In light of today’s super-strong jobs report (312K jobs added versus 177K expected), the Cautious Optimism Correspondent for Economic Affairs and Other Egghead Stuff is reminded of former Clinton administration Treasury Secretary, Harvard President, and World Bank Chief Economist Larry Summer’s economic predictions made during the 2016 presidential campaign.

Yes, Larry Summers predicted in June 5, 2016’s Washington Post that a Trump election victory would bring a “protracted” global recession within eighteen months.

Whether he meant eighteen months after a November 8, 2016 election or eighteen months after a January 20, 2017 inauguration isn’t entirely clear. But taking Summers verbatim at his word (“if he [Trump] were elected, I would expect a protracted recession to begin within 18 months) we have to go with election day.

Eighteen months later was May 8, 2018 so Summers was wrong plus another seven months to boot and counting.

Now all that said, the Economics Correspondent still worries about recession. One day there will inevitably be one, and the Federal Reserve is working overtime to create one even if the Fed governors may not understand completely how their imposition of price ceilings on savings and capital sets up the U.S. economy for booms and inevitable busts.

(On a side note, the Economics Correspondent was worried all the way back in mid-2016 about a Fed-induced recession during a Trump presidency and actually advocated to his friends that a Hillary Clinton presidency with an obstructionist GOP Congress might be a better long term scenario since the Fed would dump a recession in Hillary’s lap instead… OK, say ten Hail Marys and I’m forgiven)

But regardless of what the Fed does going forward Summers’ hourglass sands have run out. Like most statist Keynesians he’s made yet another wrong prediction—this one particularly alarmist and designed to frighten voters into choosing his candidate.

And I thought it was Trump who fosters fear for political gain.

Eighteen months have come and gone and there’s no protracted global recession now nor was there one any time leading up to and including May 8, 2018.

So tally up yet another dead wrong prediction by a Keynesian economist joining the likes of Paul Samuelson, Arthur Okun, Alvin Hansen, Joan Robinson, Joseph Stiglitz, Ben Bernanke, Paul Krugman, and of course John Maynard Keynes himself.

ps. If a recession does begin in the next six months or year and the culprit is the Fed's tightening of monetary policy after eight years of distortive zero percent interest rates, don't expect Summers to make that differentiation. Neither I'm sure will the mainstream media.

pps. LOL from Summers' June 5, 2016 Washington Post opinion piece:

"Trump’s authoritarian style and cult of personality surely would take a toll on business confidence."

On Some Really, Really Misleading Income Inequality Statistics

Click here to read the original Cautious Optimism Facebook post with comments

The Cautious Optimism Correspondent for Economic Affairs and Other Egghead Stuff makes a hefty correction to some really misleading income inequality statistics.

Click photo to see detailed household income statistics

(Thanks to Russ Roberts of George Mason University's Mercatus Center for bringing these statistical adjustments to my attention)

2 MIN READ - Missing from the seemingly endless headlines bemoaning lopsided income inequality between the top quintile of American earners and the bottom quintile are, well, comparisons of actual incomes.

How can that be? After all the Census Bureau has reported that in 2016 the highest fifth of U.S. earners collected an average annual income of $213,941 versus a mere $12,942 for the bottom fifth. 

Hence politicians and the media have loudly lamented that the top 20% “earns seventeen times more” than the bottom 20%. Shouldn't we be alarmed?

Nope. Because they're not comparing actual incomes.

As they say statistics can be framed just about any way to tell just about any story. Problem is if it weren’t for a few critically missing mathematical adjustments we might actually believe the hype that income inequality is really that bad.

It’s not. A conveniently missing qualification from the press headlines is that their reported income numbers reflect household income, not individual income. And an even more critical omission is the average number of workers per household.

So 2016’s top income quintile households contained a mean of 2.04 workers (raw data in attached table). It's 2.04 because most households in the top 20% are married couples in their prime earning years, both working sometimes with a teenage child here or there earning a little extra income which pushes the household mean slightly above two workers. Those statistics are plainly obvious in the table data under “Marital Status.”

2016’s bottom quintile households contained a mean of 0.43 workers.

Yes, 0.43 workers per household.

Why less than one worker? Because the bottom quintile is overrepresented by single-parent households, the very young and the very old who are often retirees—also in the data under “Age of Householders.”

So what conclusion can be drawn or more precisely redrawn from these statistics? Well when dividing household incomes by the actual number of people earning an income, the average salary drawn for workers (workers, not households but actual workers) in the top and bottom household quintiles narrows to $104,873 vs $30,098.

That’s not seventeen times more. That’s 3.5 times more. Not quite the herculean gap the press and certain politicians dunk our ears in daily.

Furthermore, the share of top quintile households with no one working at all (zero workers) is 3.8%. In the lowest quintile it’s 62.6%.

Finally workers in the top quintile are 4.4 times more likely to have a college degree than workers in the bottom quintile. And stunningly, workers in the bottom quintile are 12 times more likely to have no high school degree than workers in the top.

So now a new, very different, and much more informed question has to be asked: Is it unfair for largely college educated workers in their prime earning years to make 3.5 times more than high school dropouts who are disproportionately very young or very old?

Of course some on the American Left won’t be satisfied until everyone makes exactly the same income regardless of education, skill, and work ethic. But is the American dream really undermined by divisive income inequality because a nurse, software programmer, or small business owner makes 3.5 times more than say, a fast food worker, custodian, or retiree?

Don’t expect to find the answer—or even the question—in the New York Times, on CNN, or from Alexandria Ocasio-Cortez.

Mexico's New President Declares Sharp Energy U-Turn

Dismissing the U.S. private-sector led oil renaissance, Mexico’s new government backtracks to state monopoly and declining production.

Click here to read the original Cautious Optimism Facebook post with comments

Incoming President López Obrador favors the late President Cárdenas' 1938 energy policy

6 MIN READ - After barely getting off the ground in 2014, Mexico’s novel bidding auctions for foreign firms to develop its energy assets are quickly being reversed. This week incoming President Andrés Manuel López Obrador announced the auctions are being cancelled, and he placed new conditions on existing contracts that could lead to their annulments in as little as three years.

(read the original AFP article for an excellent summary of Mexico's oil quandries
https://www.france24.com/en/20181212-mexico-cancels-oil-auctions-under-new-president)

To understand the significance of this rapid U-turn, a brief history of Mexico’s state owned oil and gas industry can be instructive.

In 1938 Mexican socialist populist president Lázaro Cárdenas (founder of the PRM party, the precursor to today’s PRI) nationalized American, British, and Dutch oil assets and established the national oil company Petróleos Mexicanos, better known as Pemex.

After bitterness over the expropriation and an ugly dispute over compensation, Pemex was granted an exclusive monopoly over all Mexican oil and natural gas exploration and production, and the Mexican constitution has disallowed any foreign investment or partnership in domestic energy assets since. For over 75 years Pemex held this monopoly, and much like OPEC’s member nations the Mexican federal government has drawn heavily on Pemex revenues to fund its own budget.

However for the last two-plus decades that monopoly has come at a steep price. Pemex, being walled off from the rest of the world, has fallen hopelessly behind in exploration, drilling, and production investment and technology. The result has been a steady decline in output as mature oilfield recovery rates have slumped while new discoveries have been rare and sporadic.

In a telling statistic, Pemex’s production levels stood at a mere 1.99 million barrels per day in 2017, a 22-year low that was checked only by the anomaly of Hurricane Roxanne temporarily hampering production in 1995. Prior to Roxanne, the last year daily production fell below 2 million barrels was 1979, meaning output stands at a near 40-year low.

Another gloomy indicator: since 2004 Mexican oil production has declined from 3.4 million barrels per day to 1.9 million in 2018, down nearly 46%.

By comparison during the same period the U.S. private, open, and competitive energy market has more than doubled American oil production from 5.4 million barrels per day in 2004 to 11.6 million today. Fourteen years ago the U.S. produced 59% more oil than Mexico. Today it's 510% more.

Meanwhile Pemex, which provides the Mexican government 40% of its budget revenues, has had cash so heavily drained by federal transfers that it has been unable to fund even its own investments, leading to not only a lag in technological prowess but also inability to expand or even maintain its own legacy assets.

Despite having a legal monopoly over Mexico’s considerable energy assets, Pemex has not made a profit since 2006.

Adding insult to injury, Pemex and Mexican officials have watched as U.S. and European energy firms make deepwater discovery after discovery on the U.S. side of the Gulf of Mexico’s maritime border and quickly extract oil and natural gas from the ocean floor. But Pemex’s technology is so outdated that it can neither find the oil on its side of the border nor can it reach and develop the few resources it’s been able to find.

The same is true of Mexico’s shale oil assets which sit untouched even as right across the border U.S. firms apply new hydraulic fracturing techniques that have ushered in the new American oil renaissance.

The past two Mexican Presidents (Felipe Calderón and recently departed Enrique Peña Nieto) both recognized this problem and worked tirelessly in endless negotiations with the Mexican legislature to amend its laws and constitution to end the Pemex monopoly and allow foreign firms to partner with Pemex or develop oilfields on their own. The hope was that Mexico would receive a badly needed boost in foreign investment and more importantly benefit from the introduction of modern energy technology and expertise.

After over a decade of wrangling, Peña Nieto finally succeeded in changing Mexico’s constitution in 2013 and western firms began bidding in auctions for contracts in 2014—slowly at first and then accelerating particularly in 2018 as oil prices began recovering from their 2016 depression lows.

The auctions to date have produced contracts that would bring in $160 billion in revenue to the Mexican government (13.9% of GDP, the equivalent of $2.8 trillion in federal revenues if calculated as the same share of U.S. GDP) plus new technology and oilfield development. Under the new contracts, the government would receive up to 67% of profits from the private sale of public oil and natural gas (versus 55% in the U.S.).

And the contracts haven’t come a moment too soon. Mexican production has floundered to the point that the oil-rich country was forced into the embarrassing position of importing light Bakken crude from U.S. energy firm Phillips 66 in November, its refineries running below capacity due to low Mexican crude supplies.

Enter newly installed socialist president Andrés Manuel López Obrador.

López Obrador has slammed the Phillips 66 light crude import plan and argued the national humiliation is a direct consequence of Mexico’s failed capitalist policies.

Recently tweeting “This announcement ... is another example of the great failure of neo-liberal economic policies in the last 30 years,” López Obrador failed to mention that those allegedly neo-liberal policies included coddling a state-run monopoly for 26 of those 30 years.

Now that López Obrador is President, he’s announced a sharp U-turn back to the days of state monopoly, cancelling all remaining auctions and denouncing his predecessors’ “opening of the sector to private and foreign companies as a corruption-riddled ‘farse.’”

While López Obrador has hinted that he will honor previously signed contracts, he left the door open for reneging on even those agreements, declaring [from AFP] “companies should show they are following through on their promised investments within three years or have their oil blocks taken away.”

What level of follow-through will trigger repossession of assets is not clear, but if oil prices should fall further over the next three years energy firms would predictably hold back on investment waiting for higher prices, giving López Obrador the excuse to re-nationalize those oilfields and other assets.

Unfortunately López Obrador’s 1938-style approach to Mexican energy echoes of the same nationalization formulas that have been repeatedly tried and failed by successive Latin American governments over the last century including Salvador Allende’s Chile, Peron and Kirchner’s Argentina, Hugo Chavez’s notorious disaster in Venezuela, and of course Mexico itself whose oil industry has been dying a slow death for decades precisely because of its outdated state monopoly.

Or as former President Peña Nieto summarized in March of 2018:

“Those who call for a repeal of Energy Reform would condemn our country to return to an outdated, obsolete model that no longer works anywhere else in the world.”

López Obrador says instead of inviting foreign investment, he wants his PRD government itself to inject an initial $9.4 billion into Pemex to remodernize the company. In his eyes Pemex doesn’t need outside help from the rest of the world and can solve its problems on its own.

But experts are skeptical that López Obrador’s plan will be enough, citing costs of $10-$15 billion simply to construct one new refinery. And the previous Peña Nieto government calculated Mexico needs over $600 billion in investment to boost output to 2004’s level of 3.4 million barrels per day by 2032.

López Obrador, who has promised to stamp out Mexico’s longstanding government corruption problem, claims his proposed investments will be sufficient once he rids Pemex of corruption too. While his highly publicized campaign promises to solve corruption in Mexico are admirable, it remains to be seen how successful he’ll be given its longstanding legacy in Latin America. López Obrador, who also appears publicly without security, might want to consider hiring some bodyguards too.

But meanwhile Mexico’s northern neighbor, which is not blessed with vast amounts of “easy oil” and endures the curse of private for-profit energy development, is living through a realtime energy revolution that has vaulted it to the world’s number one oil and natural gas producer. At the same time Mexico’s Pemex will continue to languish in production decline for at least the next several years—at least until López Obrador’s vision of a reinvigorated Pemex state monopoly begins setting new production records.