Tag: recession

We are recreating the “free market” conditions for The Great Depression!

Posted on by Lawrence

Could half of America’s banks suddenly go bankrupt and unemployment reach 25 percent of our labor force? If you are focused solely on the federal government’s deficit spending, you are missing a much bigger threat to our economy. It is our private banking system and how we are gradually and systematically removing the regulations that were put in place in the 1930s to ensure our financial safety, security and stability. The Trump advisors’ plan to abolish the Federal Deposit Insurance Corporation (FDIC) and transfer its function to the Treasury Department is just the latest is a series of deregulation moves over many years that have been setting us up for another Great Depression. To understand all this, we must first understand how our banking system actually works.

People naturally think that if they deposit ten one-hundred dollar bills (a thousand dollars) into a bank savings account, then the bank can take that money and loan it out to some business or person seeking a loan. Occasionally, a loan might go bad, but if the bank charges a high enough interest rate on loans (relative to the interest rate on savings that it gives to you), it can usually still make a profit, even when a few loans go bad. That sounds like a reasonably stable system. But it is not at all the banking system we have.

What most people don’t understand is that for many years prior to March 2020, if you put a thousand dollars into a savings account at a bank, then that bank could legally loan out as much as ten times as much money as you had deposited. This was known as our fractional reserve banking system. You put a thousand dollars in the bank. The bank doesn’t touch those ten one-hundred dollar bills. They can just sit there. What really happens as a result of your putting a thousand dollars into a savings account is that the bank can now loan out ten times as much money as you have deposited (prior to March 2020).

Someone who is a good cook decides that they would like to open a restaurant. But they need a loan to get the equipment, pay the rent and hire some restaurant workers to get things started. They go to a bank and ask for a loan of ten thousand dollars. Prior to March 2020, based on your deposit of one thousand dollars, the bank can create a bank account worth ten thousand dollars out of “thin air.” The bank doesn’t even need to touch your ten one-hundred dollar bills. It just creates an account out of “thin air.” The good cook can just write checks on that account as if it were real money, because it is real money. Most of the money in our economy is created by our private banks. (Note: The Federal Reserve can adjust the amount of money in circulation on the margin and move short-term interest rates up or down.)

This fractional reserve system is a lot more risky than just loaning out the money you deposited. The bank can get way out over its skis in making loans if it is not careful. Before fractional reserve banking was created in 1933, banks had no limits on creating loans out of “thin air.” The Great Depression demonstrated the danger of counting on the banking system to restrain itself. Allowing free market “creative destruction” to destroy our economy from time to time does not seem reasonable. That is why reserve requirement regulations were imposed on the free market.

The Glass-Steagall Act of 1933 was enacted by Congress to prevent banks from engaging in speculative and highly risky investments by separating commercial depository banking from investment banking. The Glass-Steagall Act was repealed and replaced with the Gramm-Leach-Bliley Act in 1999, which some people argue led to the 2007-2009 Great Recession. This freed up local banks to transfer local bank risk to Wall Street through such instruments as mortgage-backed securities. Local banks are more likely to understand local risks that don’t show up in the standard accounting measures. Local banks may know more about the backgrounds of individuals or businesses seeking loans. Transferring hidden risks to Wall Street protected the local banks but made the whole system less stable by making a lot more loans that were much more likely to fail.

Insurance is a way to cover threats to your health, your property or your business. However, even with insurance, you still have some incentive to protect yourself, your property and your business. But credit default swaps (CDSs) enable you to bet on someone else’s debt. You may have knowledge that the owner, the bank or the mortgage company don’t have, or you may even have an incentive to cash in on a debt default when you could have taken action to prevent the default on the debt. You might even think of CDSs as facilitating something like insider trading where you short a stock when you have insider knowledge about something bad that is about to happen.

For many years, under the Banking Act of 1935, which was passed in response to the bank failures in the Great Depression, the Federal Reserve typically required deposits of at least ten percent of the value of a bank’s total loans under our traditional fractional reserve banking system. But in March 2020,[1] after President Trump appointed new members to the Federal Reserve Board, the Federal Reserve went in the opposite direction and reduced the fraction of deposits that must be held on reserve to zero percent, effectively eliminating the reserve requirements for all depository institutions. This means that banks can now create as much money out of “thin air” as they want, whenever they want. Were you worried about the Federal government increasing the Federal debt? The private sector already creates more than ninety percent of the money in our economy and is now in a position to create even more money than that whenever it wants.

Under “The Chicago Plan”, which is based on the work of conservative economists Frank Knight and Henry Simons of the University of Chicago and Irving Fisher of Yale University in the 1930s, fractional reserve banking would be eliminated and replaced with one hundred percent reserve banking so that private banks could no longer create money out of “thin air” and could only loan out money that they actually had in deposits.[2] Somehow, since then, the meanings of the words “conservative” and “radical” seem to have been switched. Regulations that were deemed “prudent” before are now considered “government overreach.”

After all, it was the private financial system that collapsed and brought on the Great Depression and many recessions since then, yet the enormous money creation by banks with very little in the way of assets to back up their loans is generally ignored by economists and the general public which instead focus solely on federal government debt. In March 2023, Silicon Valley Bank, Signature Bank, Silvergate Bank and First Republic Bank all failed due to the drop in the value of the assets backing up their loans and investments.[3]

The real threat to our economic stability is less about the federal government’s debt and more about the debt of banks with inadequate assets to back up their creation of money out of “thin air.” Too often we face a private debt crisis and then just go back to focusing on and complaining about the federal public debt. The federal debt problem should not be ignored, but the instability brought on by the enormous growth in private debt of both banks and individuals should not be ignored either.

Prior to the 1929 stock market crash and the Great Depression the money flow had become more and more distorted with an ever greater portion of it flowing into the hands of the wealthiest people, who kept reinvesting it in the financial markets in an attempt to compete with others in building up their wealth as a measure and sign of their self-worth. The inflation that this distorted money flow created in the stock prices in the financial economy on Wall Street was ignored, because it didn’t show up in the usual inflation indices that measure inflation in the real economy on Main Street.

In the old days, many people believed that unrestricted free enterprise including unregulated financial markets were necessary for a healthy economy. Few people anticipated the financial collapse that followed the stock market crash in 1929 with half of the nation’s 25,000 banks destroyed and the unemployment rate reaching 25 percent. Before the Great Depression that lasted for ten years from 1929 to 1939, most economists believed in Schumpeter’s creative destruction where occasional economic downturns were seen as part of a necessary cleansing process to weed out less efficient enterprises. The money flow paradigm sees this as more of a competition destruction where many small mom and pop restaurants and other firms with insufficient capital resources to ride out the downturn either go bankrupt or are bought up by larger companies with greater liquidity. 

Before the Great Depression most people agreed that government needed to just stay out of the way and not interfere with free markets. After the Great Depression the practical problems and deficiencies of unrestricted free markets had to be addressed. The consensus that government oversight and regulation was a necessary part of protecting and preserving free enterprise more or less held until the election of Ronald Reagan as president of the United States in 1980.

Following President Reagan’s dictate that “government is best that governs least”, in 1982 the Securities and Exchange Commission (SEC) removed the prohibition on corporations buying back their own stock in the stock market. Prior to 1982 stock buybacks were considered insider trading and illegal. After 1982 stock buybacks were allowed along with all the manipulations and distortions that they introduced into the stock market.

The Efficient Market Hypothesis was considered sacrosanct so whatever prices the stock market produced were considered optimal in being efficiently based on all available information. Conservative Federal Reserve chair Alan Greenspan’s warning about irrational exuberance was ignored even after the 2000 to 2001 stock market crash and the 2007 to 2009 Great Recession.

Occasionally wiping out a lot of the retirement savings of some elderly people with the switch from companies providing defined benefits in the form of pensions to instead providing defined contributions in a 401K Individual Retirement Account (IRA) was just considered part of the risk that individuals had to bear under the deregulation agenda.

Even today politicians following President Reagan’s conservative doctrine justify the ever increasing concentration of American industries on the need to benefit from the economies of scale and network effects that such concentration bring even when those benefits go to fewer and fewer ever more wealthy people. Instead of lots of firms competing in an industry with occasionally one going bankrupt from a poor strategy or bad luck, the government watchdogs set aside such concerns and frequently bet an entire industry on one very large firm or a few large firms by ignoring the anti-trust laws and allowing the number of firms in many American industries to be consolidated.

The deregulation agenda was facilitated by the Supreme Court’s Citizens United ruling in 2010 which declared that corporations were people and entitled to the same freedom of speech rights as people. This ruling opened the way for corporations and wealthy individuals to directly or indirectly support politicians running for office who promoted the deregulation agenda.

It will be interesting to see how far out on the deregulation limb the United States can go in introducing more and more instability before the whole thing collapses in another Great Depression. It is ironic that the MAGA rebellion against the “know-it-all” intellectual elite (e.g., Dr. Anthony Fauci) is now being run by billionaires representing the financial elite (e.g., Elon Musk). The conflict over H1B visa technology immigrants is just the tip of the iceberg when it comes to the inherent conflict between Trump’s MAGA base and the billionaire agenda. Let’s hope that people wake up and realize where this is all heading before it is too late.

[1]  https://en.wikipedia.org/wiki/Reserve_requirement

[2] Fisher, Irving. “100% Money.” working paper. https://cdn.mises.org/100%20Percent%20Money_Fisher.pdf

[3] https://en.wikipedia.org/wiki/2023_United_States_banking_crisis

The Money Flow Paradigm

Posted on by Lawrence

The long-term fundamental problem facing our economy is the enormous diversion of money flow from everyday people on Main Street to investors in the New York financial markets on Wall Street. This diversion began in the late 1970s and early 1980s and has continued in subsequent decades such that the people on Main Street are no longer able to buy back the value of the goods and services that they produce at full employment. This distortion in the money flow has driven up stock and bond prices and driven down interest rates and caused a majority of Americans to pile up large amounts of private debt. Yet this has not been enough to maintain full employment so the federal government has had to run large deficits under both Republican (massive tax cuts) and Democratic (massive stimulus spending) to keep most of the labor force fully employed. This has resulted in an ever increasing level of both private debt and public debt.

The money flow paradigm recognizes how the financial economy has become more and more separated from the real economy and how the diversion of the money flow from Main Street to Wall Street has become a serious problem that undermines economic stability by producing both inflations and recessions and requires the continual vigilance and action by those responsible for both our fiscal and monetary policies. The financial economy has become more of a gambling casino and less of a venue for providing money for investment in the production of new goods and services in the real economy.

During the French revolution Marie Antoinette was reported to have said: “Let them eat cake.” Today Marie Antoinette is essentially saying: “Let them eat plastic” as credit cards are widely distributed as an alternative to rewarding hard work and creativity with adequate compensation. Roth accounts reward heirs with tax-free inheritances while income taxes are used to undermine work incentives and discourage workers and entrepreneurs.

Several commentators have pointed out that the most important choice you make in your life is your choice of parents. If you choose rich, well-educated parents, you have a very high probably of doing well financially, while those who have chosen poor, poorly-educated parents cannot expect to get very far financially. Hard work pays off, but not for the person doing the hard work. The workers’ hard work pays off for the shareholder who reaps the reward for many years after an initial investment, which keeps doubling in value under compound interest and dividend reinvestment.

By following the flow of money, the money flow paradigm makes the problem clear, especially since the investors on Wall Street typically have much more wealth and, therefore, much lower marginal propensities to consume than the people on Main Street. The top ten percent of wealthy people purchase new goods and services with only about 8 percent of each additional dollar while the bottom ten percent in wealth consume about 94 percent of every additional dollar on new goods and services. Giving more money to those on Wall Street is very ineffective in stimulating the economy. Such attempts to stimulate the economy during economic downturns have been described as pushing on a string. Clearly you can get more bang for the buck by stimulating the spending of the people on Main Street instead of trying to stimulate the economy by buying bonds and mortgage-backed securities from the people on Wall Street. Applying Milton Friedman’s negative income tax, which targets low income people, would be much more effective and get much faster results than giving more money to the wealthiest Americans who just buy more stocks and bonds or bid up the price of Picasso paintings and exclusive properties with little or no effect on the production of new goods and services in the real economy.

Conversely, when excessive inflation is the problem, raising the cost of borrowing by increasing interest rates in the financial markets suppresses both supply and demand with the economy driven towards recession. A business that has maxed out its production trying to satisfy excessive demand with its existing lines of production would like to add another line of production but finds that the cost of borrowing the needed funds has gone up making it harder to afford a new line of production to increase supply. Meanwhile on the demand side the people hurt by the increase in the cost of loans are those trying to replace their rusty truck or obtain a mortgage to buy a new house. These tend to be the lower income people who do not have the cash on hand to buy a vehicle or a home without a loan. Why do we continue to use a cost-of-borrowing tool to fight inflation that suppresses supply and punish the poorest Americans in a very ineffective manner when instead we could be using a much more efficient return-on-savings tool?

The money flow paradigm tells us that a much more effective and efficient method of suppressing inflation is to increase the return on savings substantially without increasing the cost of borrowing. Private banks cannot afford to do this because they must earn more on loans than they pay on savings. But the Federal Reserve, which generates many billions of dollars in profits from its investments each year, is in a position to offer high interest rates on savings. In effect this is what was done at the start of World War II when the supply of new consumer goods and services was dramatically disrupted by switching to the production of tanks, warplanes, and warships and sending large numbers of young men to fight in Europe and Asia. High interest rate war bonds were vigorously promoted with celebrities singing and dancing and extensive advertising throughout the war until approximately 50 percent of American families had purchased war bonds. This helped substantially in constraining demand for consumer goods and avoiding inflation.

The Postal Savings Act of 1910 allowed anyone to go to any post office and set up a small savings account. Such savings accounts were restricted to some maximum allowable amount and were available to all Americans for over 50 years. Such government sponsored savings accounts still exist in a number of other developed nations. However, this promotion of savings by Americans was discontinued in 1966. Were such accounts available today, the government could offer an exceptionally high interest rate on savings to get low income people to put off buying that new pair of shoes in favor of investing $100 into their own postal savings account. As with the war bonds during World War II, this would provide a return-on-savings tool that would directly impact the real economy on Main Street instead of using the cost-of-borrowing tool that operates through Wall Street and suppresses both supply and demand and typically leads to a recession. Getting people to save more not only gives them a savings account to help them deal with an unexpected rent increase, a medical emergency, an automobile accident, or a job loss, but also provides the real economy with an automatic stabilizer to allow the economy to absorb some financial disruptions without triggering inflations and recessions.

By following the money flow, the money flow paradigm provides a much deeper and more realistic understanding of our economy and what we need to do to avoid inflations and recessions. It is much better at explaining how economics actually works than the old neoclassical, monetarist, and Keynesian paradigms and their more recent variations.

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