America's Great Depression (10 page)

24

America’s Great Depression

Obviously, since credit expansion necessarily sows the seeds of later depression, the proper course for the government is to stop any inflationary credit expansion from getting under way. This is not a very difficult injunction, for government’s most important task is to
keep itself
from generating inflation. For government is an
inherently inflationary institution
, and consequently has almost always triggered, encouraged, and directed the inflationary boom.

Government is inherently inflationary because it has, over the centuries, acquired control over the monetary system. Having the power to print money (including the “printing” of bank deposits) gives it the power to tap a ready source of revenue. Inflation is a form of taxation, since the government can create new money out of thin air and use it to bid away resources from private individuals, who are barred by heavy penalty from similar “counterfeiting.” Inflation therefore makes a pleasant substitute for taxation for the government officials and their favored groups, and it is a subtle substitute which the general public can easily—and can be encouraged to—overlook. The government can also pin the blame for the rising prices, which are the inevitable consequence of inflation, upon the general public or some disliked segments of the public, e.g., business, speculators, foreigners. Only the unlikely adoption of sound economic doctrine could lead the public to pin the responsibility where it belongs: on the government itself.

Private banks, it is true, can themselves inflate the money supply by issuing more claims to standard money (whether gold or government paper) than they could possibly redeem. A bank deposit is equivalent to a warehouse receipt for cash, a receipt which the bank pledges to redeem at any time the customer wishes to take his money out of the bank’s vaults. The whole system of

“fractional-reserve banking” involves the issuance of receipts which cannot possibly be redeemed. But Mises has shown that, by themselves, private banks could not inflate the money supply by a great deal.22 In the first place, each bank would find its newly 22See Mises,
Human Action,
pp. 429–45, and
Theory of Money and Credit
(New Haven, Conn.: Yale University Press, 1953).

The Positive Theory of the Cycle

25

issued
uncovered
, or “pseudo,” receipts (uncovered by cash) soon transferred to the clients of other banks, who would call on the bank for redemption. The narrower the clientele of each bank, then, the less scope for its issue of pseudo-receipts. All the banks could join together and agree to expand at the same rate, but such agreement would be difficult to achieve. Second, the banks would be limited by the degree to which the public used bank deposits or notes as against standard cash; and third, they would be limited by the confidence of the clients in their banks, which could be wrecked by runs at any time.

Instead of preventing inflation by prohibiting fractional-reserve banking as fraudulent, governments have uniformly moved in the opposite direction, and have step-by-step removed these free-market checks to bank credit expansion, at the same time putting themselves in a position to direct the inflation. In various ways, they have artificially bolstered public confidence in the banks, encouraged public use of paper and deposits instead of gold (finally outlawing gold), and shepherded all the banks under one roof so that they can all expand together. The main device for accomplishing these aims has been Central Banking, an institution which America finally acquired as the Federal Reserve System in 1913.

Central Banking permitted the centralization and absorption of gold into government vaults, greatly enlarging the national base for credit expansion:23 it also insured uniform action by the banks through basing their reserves on deposit accounts at the Central Bank instead of on gold. Upon establishment of a Central Bank, each private bank no longer gauges its policy according to its particular gold reserve; all banks are now tied together and regulated by Central Bank action. The Central Bank, furthermore, by proclaiming its function to be a “lender of last resort” to banks in trouble, enormously increases public confidence in the banking system.

23When gold—formerly the banks’ reserves—is transferred to a newly established Central Bank, the latter keeps only a fractional reserve, and thus the total credit base and potential monetary supply are enlarged. See C.A. Phillips, T.F.

McManus, and R.W. Nelson,
Banking and the Business Cycle
(New York: Macmillan, 1937), pp. 24ff.

26

America’s Great Depression

For it is tacitly assumed by everyone that the government would never permit its own organ—the Central Bank—to fail. A Central Bank, even when on the gold standard, has little need to worry about demands for gold from its own citizens. Only possible drains of gold to foreign countries (i.e., by non-clients of the Central Bank) may cause worry.

The government assured Federal Reserve control over the banks by (1) granting to the Federal Reserve System (FRS) a monopoly over note issue; (2) compelling all the existing “national banks” to join the Federal Reserve System, and to keep all their legal reserves as deposits at the Federal Reserve24; and (3) fixing the minimum reserve ratio of deposits at the Reserve to bank deposits (money owned by the public). The establishment of the FRS was furthermore inflationary in directly reducing existing reserve-ratio requirements.25 The Reserve could then control the volume of money by governing two things: the volume of bank reserves, and the legal reserve requirements. The Reserve can govern the volume of bank reserves (in ways which will be explained below), and the government sets the legal ratio, but admittedly control over the money supply is not perfect, as banks can keep

“excess reserves.” Normally, however, reassured by the existence of a lender of last resort, and making profits by maximizing its assets and deposits, a bank will keep fully “loaned up” to its legal ratio.

While unregulated private banking would be checked within narrow limits and would be far less inflationary than Central Bank 24Many “state banks” were induced to join the FRS by patriotic appeals and offers of free services. Even the banks that did not join, however, are effectively controlled by the System, for, in order to obtain paper money, they must keep reserves in some member bank.

25The average reserve requirements of all banks before 1913 was estimated at approximately 21 percent. By mid-1917, when the FRS had fully taken shape, the average required ratio was 10 percent. Phillips et al. estimate that the inherent inflationary impact of the FRS (pointed out in footnote 23) increased the expansive power of the banking system three-fold. Thus, the two factors (the inherent impact, and the deliberate lowering of reserve requirements) combined to inflate the monetary potential of the American banking system six-fold as a result of the inauguration of the FRS. See Phillips, et al.
, Banking and the Business Cycle,
pp. 23ff.

The Positive Theory of the Cycle

27

manipulation,26 the clearest way of preventing inflation is to outlaw fractional-reserve banking, and to impose a 100 percent gold reserve to all notes and deposits. Bank cartels, for example, are not very likely under unregulated, or “free” banking, but they could nevertheless occur. Professor Mises, while recognizing the superior economic merits of 100 percent gold money to free banking, prefers the latter because 100 percent reserves would concede to the government control over banking, and government could easily change these requirements to conform to its inflationist bias.27

But a 100 percent gold reserve requirement would not be just another administrative control by government; it would be part and parcel of the general libertarian legal prohibition against fraud. Everyone except absolute pacifists concedes that violence against person and property should be outlawed, and that agencies, operating under this general law, should defend person and property against attack. Libertarians, advocates of laissez-faire, believe that “governments” should confine themselves to being defense agencies only. Fraud is equivalent to theft, for fraud is committed when one part of an exchange contract is deliberately not fulfilled after the other’s property has been taken. Banks that issue receipts to non-existent gold are really committing fraud, because it is then impossible for all property owners (of claims to gold) to claim their rightful property. Therefore, prohibition of such practices would not be an act of government
intervention
in the free market; it would be part of the general legal
defense
of property against attack which a free market requires.28, 29

26The horrors of “wildcat banking” in America before the Civil War stemmed from two factors, both due to government rather than free banking: (1) Since the beginnings of banking, in 1814 and then in every ensuing panic, state governments permitted banks to continue operating, making and calling loans, etc. without having to redeem in specie. In short, banks were privileged to operate without paying their obligations. (2) Prohibitions on interstate branch banking (which still exist), coupled with poor transportation, prevented banks from promptly calling on distant banks for redemption of notes.

27Mises,
Human Action,
p. 440.

28A common analogy states that banks simply count on people not redeeming all their property at once, and that engineers who build bridges operate also on
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America’s Great Depression

What, then, was the proper government policy during the 1920s? What should government have done to prevent the crash?

Its best policy would have been to liquidate the Federal Reserve System, and to erect a 100 percent gold reserve money; failing that, it should have liquidated the FRS and left private banks unregulated, but subject to prompt, rigorous bankruptcy upon failure to redeem their notes and deposits. Failing these drastic measures, and given the existence of the Federal Reserve System, what should its policy have been? The government should have exercised full vigilance in not supporting or permitting any inflationary credit expansion. We have seen that the Fed—the Federal Reserve System—does not have complete control over money because it cannot force banks to lend up to their reserves; but it does have absolute anti-inflationary control over the banking system. For it does have the power to reduce bank reserves at will, and thereby force the banks to cease inflating, or even to contract if necessary. By lowering the volume of bank reserves and/or raising reserve requirements, the federal government, in the 1920s as well as today, has had the absolute power to prevent any increase in the total volume of money and credit. It is true that the FRS has no direct control over such money creators as savings banks, savings and loan associations, and life insurance companies, but any credit the principle that not everyone in a city will wish to cross the bridge at once. But the cases are entirely different. The people crossing a bridge are simply requesting a service;
they are not trying to take possession of their lawful property,
as are the bank depositors. A more fitting analogy would defend embezzlers who would never have been caught if someone hadn’t fortuitously inspected the books. The crime comes when the theft or fraud is
committed
, not when it is finally revealed.

29Perhaps a libertarian legal system would consider “general deposit warrants” (which allow a warehouse to return any homogeneous good to the depositor) as “specific deposit warrants,” which, like bills of lading, pawn tickets, dock-warrants, etc. establish ownership to specific, earmarked objects. As Jevons stated, “It used to be held as a general rule of law, that any present grant or assign-ment of goods not in existence is without operation.” See W. Stanley Jevons,
Money and the Mechanism of Exchange
(London: Kegan Paul, 1905), pp. 207–12.

For an excellent discussion of the problems of a fractional-reserve money, see Amasa Walker,
The Science of Wealth
(3rd ed., Boston: Little, Brown, 1867), pp.

126–32, esp. pp. 139–41.

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29

expansion from these sources could be offset by deflationary pressure upon the commercial banks. This is especially true because commercial bank deposits (1) form the monetary base for the credit extended by the other financial institutions, and (2) are the most actively circulating part of the money supply. Given the Federal Reserve System and its absolute power over the nation’s money, the federal government, since 1913, must bear the complete responsibility for any inflation. The banks cannot inflate on their own; any credit expansion can only take place with the support and acquiescence of the federal government and its Federal Reserve authorities. The banks are virtual pawns of the government, and have been since 1913. Any guilt for credit expansion and the consequent depression must be borne by the federal government and by it alone.30

PROBLEMS IN THE AUSTRIAN THEORY

OF THE TRADE CYCLE

The “Assumption” of Full Employment

Before proceeding to discuss alternative business cycle theories, several problems and time-honored misconceptions should be cleared up. Two standard misconceptions have already been refuted by Professor Mises: (1) that the Austrian theory “assumes” the previous existence of “full employment,” and therefore does not apply if the credit expansion begins while there are unemployed factors, and (2) that the theory describes the boom as a period of “overinvestment.” On the first point, the unemployed factors can either be labor or capital-goods. (There will always be unemployed, submarginal,
land
available.) Inflation will only put unemployed labor factors to work if their owners, though otherwise 30Some writers make a great to-do over the legal fiction that the Federal Reserve System is “owned” by its member banks. In practice, this simply means that these banks are taxed to help pay for the support of the Federal Reserve. If the private banks really “own” the Fed, then how can its officials be appointed by the government, and the “owners” compelled to “own” the Federal Reserve Board by force of government statute? The Federal Reserve Banks should simply be regarded as governmental agencies.