Let’s first set the record straight on Herbert Hoover’s fiscal policies. Contrary to what you have heard and read over the last year, Hoover behaved as a textbook Keynesian after the stock market crash. He immediately cut income tax rates by one percentage point (applicable to the 1929 tax year) and began ratcheting up federal spending, increasing it 42 percent from fiscal year (FY) 1930 to FY 1932.

But to truly appreciate Hoover’s Keynesian bona fides, we must realize that this enormous jump in spending occurred amidst a collapse in tax receipts, due both to the decline in economic activity as well as the price deflation of the early 1930s. This combination led to unprecedented peacetime deficits under the Hoover Administration—something FDR railed against during the 1932 campaign!

How big were Hoover’s deficits? Well, his predecessor Calvin Coolidge had run a budget surplus every single year of his own presidency, and he held the federal budget roughly constant despite the roaring prosperity (and surging tax receipts) of the 1920s. In contrast to Coolidge—who was a true small-government president—Herbert Hoover managed to turn his initial $700 million surplus into a $2.6 billion deficit by 1932.

It’s true, that doesn’t sound like a big number today; Henry Paulson handed out more to bankers by breakfast. But keep in mind that Hoover’s $2.6 billion deficit occurred because he spent $4.6 billion while only taking in $2 billion in tax receipts. Thus, as a percentage of the overall budget, the 1932 deficit was astounding—it would translate into a $3.3 trillion deficit in 2007 (instead of the actual deficit of $162 billion that year). For another angle, I note that Hoover’s 1932 deficit was 4 percent of GDP, hardly the record of a Neanderthal budget cutter.

The real reason unemployment soared throughout Hoover’s term was not his aversion to deficits, or his infatuation with the gold standard. No, the one thing that set Hoover apart from all previous US presidents was his insistence to big business that they not cut wage rates in response to the economic collapse. Hoover held a faulty notion that workers’ purchasing power was the source of an economy’s strength, and so it seemed to him that it would set in motion a vicious cycle if businesses began laying off workers and slashing paychecks because of slackening demand.

The results speak for themselves. During the heartless “liquidationist” era before Hoover, depressions (or “panics”) were typically over within two years. Yes, it was surely no fun for workers to see their paychecks shrink quite rapidly, but it ensured a quick recovery and in any event the blow was cushioned because prices in general would fall too.

So what was the fate of the worker during the allegedly compassionate Hoover era, when “enlightened” business leaders maintained wage rates amidst falling prices and profits? Well, Econ 101 tells us that higher prices lead to a smaller amount purchased. Because workers’ “real wages” (i.e. nominal pay adjusted for price deflation) rose more quickly in the early 1930s than they had even during the Roaring Twenties, businesses couldn’t afford to hire as many workers. That’s why unemployment rates shot up to an inconceivable 28 percent by March 1933.

“This is all very interesting,” the skeptical reader might say, “but it’s undeniable that the huge spending of World War II pulled America out of the Depression. So it’s clear Herbert Hoover didn’t spend enough money.”

Ah, here we come to one of the greatest myths in economic history, the alleged “fact” that US military spending fixed the economy. In my book I relied very heavily on the pioneering revisionist work of Bob Higgs, who has shown in several articles and books that the US economy was mired in depression until 1946, when the federal government finally relaxed its grip on the country’s resources and workers.

Sure, unemployment rates dropped sharply after the US began drafting men into the armed forces. Is that so surprising? By the same token, if Obama wanted to reduce unemployment today, he could take two million laid-off workers, equip them with arm floaties, and send them to fight pirates. Voila! The unemployment rate would fall.

The official government measures of rising GDP during the war years is also misleading. GDP figures include government spending, and so the massive military outlays were lumped into the numbers, even though $1 million spent on tanks is hardly the same indication of true economic output as $1 million spent by households on cars.

On top of that distortion, Higgs reminds us that the government instituted price controls during the war. Normally, if the Fed prints up a bunch of money to allow the government to buy massive quantities of goods (such as munitions and bombers, in this case), the CPI would go through the roof. Then when the economic statisticians tabulated the nominal GDP figures, they would adjust them downward because of the hike in the cost of living, so that “inflation adjusted” (real) GDP would not look as impressive. But this adjustment couldn’t occur, because the government made it illegal for the CPI to go through the roof. So those official measures showing “real GDP” rising during World War II are as phony as the Soviet Union’s announcements of industrial achievements.

If the Keynesians rely on bad economic theory, and misleading history, to justify their calls for huge government deficits, the Chicago School monetarists are hardly better when they call for interest rates at zero percent (or even negative!) and blame the Depression on the Fed’s lack of willpower.

In doing research for the book, what I noticed is that from the time it opened its doors in November, 1914, all the way through 1931, the New York Fed charged its record-low rates at the very end of this period. The “discount rate” was the interest rate the Fed banks would charge on collateralized loans made to member banks. For the New York Fed, rates had bounced around since its founding, but they were never higher than 7 percent and never lower than 3 percent, going into 1929.

This changed after the stock market crash. On November 1, just a few days following Black Monday and Black Tuesday—when the market dropped almost 13 percent and then almost 12 percent back-to-back—the New York Fed began cutting its rate. It had been charging banks 6 percent going into the Crash, and then a few days later it slashed by a full percentage point. Then, over the next few years, the New York periodically cut rates down to a record-low of 1½ percent by May 1931. It held the rate there until October 1931, when it began hiking to stem a gold outflow caused by Great Britain’s abandonment of the gold standard the month before. (Worldwide investors feared the US would follow suit, so they started dumping their dollars while the American gold window was still open.)

So far my story doesn’t sound unusual. “Everybody knows” that the Fed is supposed to slash rates to ease liquidity crunches during a financial panic. It helps to ease the crisis, and provides a softer landing than if the supply of credit were fixed.

But guess what? Throughout the period we are considering, the highest the New York Fed ever charged banks was 7 percent. And the only time it did that was smack dab in the middle of the 1920-1921 depression.

Although you’ve probably never heard of it, this earlier depression was quite severe, with unemployment averaging 11.7 percent in 1921. Fortunately it was over fairly quickly; unemployment was down to 6.7 percent in 1922, and then an incredibly low 2.4 percent by 1923.

After working on these issues for my book, it suddenly became obvious to me: The high rates of the 1920-1921 depression had certainly been painful, but they had cleaned the rot out of the structure of production very thoroughly. The US money supply and prices had roughly doubled during World War I, and the record-high discount rate starting in June 1920 was a pressure washer on the malinvestments that had festered during the war boom.

Going into 1923, the capital structure in the United States was a lean, mean, producing machine. In conjunction with Andrew Mellon’s incredible tax cuts, the Roaring ’20s were arguably the most prosperous period in American history. It wasn’t merely that the average person got richer. No, his life changed in the 1920s. Many families acquired electricity and cars for the first time during this decade.

In contrast, during the early 1930s, the Fed’s rate cuts “for some reason” didn’t seem to do the trick. In fact, they sowed the seeds for the worst decade in US economic history.

It’s actually easier to see what’s going on if you forget about a central bank, and just pretend that we were living in the good old days when banks would compete with each other and there was no cartelizing overseer. Now in this environment, when a panic hits and most people realize that they haven’t been saving enough—that they wish they were holding more liquid funds right this moment than their earlier plans had provided them—what should the sellers of liquid funds do?

The answer is obvious: They should raise their prices. The scarcity of liquid funds really has increased after the bubble pops, and its price ought to reflect that new information. People need to know how to change their behavior, after all, and market prices mean something.

But in more modern times, thanks not just to Keynes but more important to Milton Friedman, central bankers now think that during the sudden liquidity crunch, they are supposed to shovel their product out the door. But in order to do that, of course, they have to water down its potency. It’s as if a wine dealer suddenly has a rush of customers for a rare vintage of which he only has 3 bottles, and his response is to put the vintage on sale but then dilute it with 9 parts water to 1 part wine. That way he can sell to all the eager customers and not pick their pocket at the same time.

Let’s try a different example: If the owner of a trucking company experiences a huge rush for his services, he might decide to postpone essential maintenance on his fleet, to take advantage of the unprecedented demand. But during this period he will be charging record shipping prices to make it worth his while to deviate from the normal, “safe” way of running his business. He will only be willing to bear the extra risk (either to the safety of his drivers or just the long-term operation of the trucks) if he is being compensated for it.

The same is true for the banks. Just as every other business during a recession wants to bolster its cash reserves, so too with the business that rents out cash reserves. If there’s a hurricane, the stores selling flashlights and generators should raise the prices on those essential items, to make sure they are rationed correctly. The same is true for liquidity, the moment after the community realizes they are in desperate need of it.

Regards,

Robert P. Murphy
for The Daily Reckoning

The Politically Incorrect Guide to the Great Depression and the New Deal originally appeared in the Daily Reckoning. The Daily Reckoning, offers a uniquely refreshing, perspective on the global economy, investing, gold, stocks and today's markets. Its been called "the most entertaining read of the day."

First, let’s look at what those penny pinchers in the federal government are up to. The Congressional Budget Office (CBO) recently released its analysis of the Obama Administration’s ten-year budget proposal. The projected deficit for (fiscal year) 2009 is a whopping $1.8 trillion. Now the president has said, in effect, that you need to spend money to save money, but the CBO projects deficits once again exceeding $1 trillion by 2018. In fact, over the whole CBO forecast from 2009-2019, the lowest the deficit ever goes is $658 billion.

This should be rather surprising to anyone who actually took Obama at his word when he promised to restore fiscal discipline to Washington. In fact, the CBO projects that the outstanding federal debt held by the public will increase from 40.8% of GDP in 2008 to 82.4% in 2019. In other words, the CBO predicts a doubling of the national debt in a mere decade.

One last thing to give you chills (and not the good kind): The CBO is not exactly a doom-and-gloom forecasting service. They’re run by the government, for crying out loud. This is the same CBO that projected at the start of the Bush Administration ten years of an accumulated $5.6 trillion in budget surpluses.

I would caution readers not to dismiss all CBO numbers as obviously meaningless. On the contrary, I think we will see the same pattern play out under Obama as under Bush: Because the CBO in both cases is grossly overstating future tax receipts, its projections for the Obama proposal are going to turn out just as rosy as they did back in 2001. Besides anemic tax receipts, if mortgage defaults continue to increase, the CBO projections on losses from the Treasury’s numerous “rescue” measures will also be far too optimistic.

In short, I think we should view the doubling of the national debt (as a share of the overall economy) over the next decade as a naïve best-case scenario.

If fiscal policy is a disaster, monetary policy is even worse. Unfortunately, the issues here get very complicated, and so it’s difficult for the layman to know whom to trust. Not only do left-wingers like Paul Krugman say that we need more inflation, but even (alleged) right-wingers like Greg Mankiw are saying the exact same thing. With all due respect, those guys are crazy.

Normally, I do my best unshaved-guy-wearing-a-sandwich-board routine by showing the scary Fed chart of the monetary base. But every time I do that, some wise guy argues that I don’t understand how our banking system works, and that because of “deleveraging” we are actually experiencing a shrinking money supply.

No, we aren’t. It’s true that there are forces tending to shrink the money supply, but Bernanke has more than overwhelmed them. All of the standard measures of the money stock went way up during 2008, even though prices (as measured by the CPI) fell in some months. For example, the monetary aggregate M1 consists of very liquid items such as actual currency held by the public, and checking account deposits. It does not include the monetary base (which we know has exploded through the roof). Even so, look at the annual percentage graph of M1 recently; it’s grown at almost a record rate:

Now the reason prices haven’t exploded is that the demand to hold U.S. dollars has also increased dramatically. (That’s also what happened in the 1980s: the Reagan tax cuts and Volcker’s squelching of severe price inflation made it much more attractive to hold dollars, and so the Fed got away with printing a bunch even though the CPI didn’t increase wildly.)

Once people get over the shock of the financial crisis, the new money Bernanke has pumped into the system will begin pushing up prices. Others have used this analogy before me, but it’s still apt: The U.S. economy right now is like Wile E. Coyote right after he runs off a cliff but hasn’t yet looked down. Once the spell of a “deflationary spiral” is broken by a full quarter of significant price hikes, there will be an avalanche as people come to their senses.

Some analysts concede that the traditional Fed policies have indeed left the dollar vulnerable to serious devaluation, but they think the central bank wizards can save the day by acquiring new “tools.” For example, San Francisco Fed president Janet Yellen has been arguing that the Fed should be able to issue its own debt, to give the Fed more flexibility. The idea is that when the time comes for the Fed to sop up the excess reserves it has pumped into the banking system, it would be devastating to the incipient economic recovery if the Fed has to dump a bunch of mortgage-backed securities, or Treasury bonds, back onto the market. This would ruin the banks with MBS on their balance sheets, and/or it would push up interest rates for the government. Thus, the Fed would have painted itself into a corner, and it would have to choose between massive CPI hikes or a renewed recession. To avoid that nasty tradeoff, Yellen argues that if the Fed could sell its own debt, then it could drain reserves out of the banking system without unloading its own balance sheet.

For a different idea, economists Woodward and Hall think the Fed just needs the ability to charge banks for holding reserves. The Fed already (recently) obtained the right to pay interest on reserves, and so Woodward and Hall think the Fed should also have the ability to do the opposite, i.e. to be able to pay a negative interest rate on reserves that banks hold on deposit with the Fed.

How does this avert the threat of hyperinflation? Simple, according to Woodward and Hall. If banks ever start loaning out too much of their (now massive) excess reserves, and thereby start causing large price inflation, then the Fed can simply raise the interest rate it pays on reserves. Banks would then find it more profitable to lend to the Fed, as it were, rather than lending reserves out to homebuyers and other borrowers in the private sector. Voila! Problem solved.

Obviously these tricks can’t avoid the consequences of Bernanke’s mad money printing spree. At best, they would merely push back the day of reckoning, while ensuring that it grows exponentially (quite literally).

A quick numerical example: Let’s say the Fed wants to drain $100 billion in reserves out of the banking system, in order to cool off rising prices. But it doesn’t want to sell off some of its assets on its balance sheet (like “toxic” mortgage-backed securities), so instead the Fed sells $100 billion worth of the brand new “Fed bonds,” as Yellen hopes.

In the beginning, this will indeed solve the problem. When people in the private sector buy the Fed-issued bonds, they write checks on their banks and ultimately those banks see their reserves go down at the Fed. There is less money held by the public, and so prices don’t rise as quickly.

But what happens when the Fed bonds mature? For example, if the Fed sold a 12-month bond paying 1% interest, then after the year has passed our private sector buyers will hand over the securities and now their checking accounts will be credited with $101 billion. At that point, the economy would be in the same position as before, only worse: there would be an extra billion in newly created reserves (because of interest on the Fed debt).

The financial gurus running our financial system and advising our political leaders aren’t even thinking two steps ahead when making their cockamamie recommendations. For those readers who share my skepticism, the solution seems clear: You need to transfer your wealth out of assets denominated in fixed streams of U.S. dollars, and switch to something that responds to large price inflation. In short, sell your corporate and government bonds, and start stocking up on precious metals.

Regards,

Robert Murphy
for The Daily Reckoning

Editor’s Note: Robert P. Murphy has a PhD in economics from NYU and is author of The Politically Incorrect Guide to the Great Depression and the New Deal (Regnery 2009). He runs the blog Free Advice.

Will New Fed “Tools” Avert Hyperinflation? originally appeared in the Daily Reckoning. The Daily Reckoning, offers a uniquely refreshing, perspective on the global economy, investing, gold, stocks and today's markets. Its been called "the most entertaining read of the day."

This Keynesian orthodoxy was shattered in the 1970s when the United States suffered through “stagflation,” which was high unemployment and high inflation. This outcome was not supposed to be possible, according to the popular macroeconomics models, and it left policy makers with no clear choice. If the Fed raised rates to stem the inflation, it would hurt the economy even more, but if the Fed cut rates (through printing more money) the inflation problem would worsen. The vacuum created by this crisis in both theory and policy was filled by the Reagan Revolution and supply-side economics.

At this stage nothing is certain, but the country is currently headed straight into a period of very rapid price hikes and a very bad recession. It would not surprise me at all if the national unemployment rate and the annualized rate of consumer price inflation both broke through into double digits by the end of 2009. Moreover, regardless of when it actually starts, I predict that things will get much worse before they get better, and that the United States will be mired in a malfunctioning economy for at least a decade, with price inflation in the double-digits (possibly higher) the entire time. We can call this condition “hyper-depression.”

As with stagflation during the 1970s, hyper-depression will blow up the prevailing “cutting edge” models of the macroeconomy. Back when he was an academic, Fed Chair Ben Bernanke was actually an expert on the Great Depression. Bernanke adheres to the (alleged) lesson taught by Milton Friedman and Anna Schwartz in their classic A Monetary History of the United States. F&S argued that Fed officials bore a large share of the blame for the Great Depression, because they did not pump in enough liquidity. The quantity of money actually declined by about a third from 1929-1933, as panicked customers withdrew cash from the banks. (In a fractional reserve banking system, when people withdraw deposits, the banks have to shrink their outstanding checking balances because of reserve requirements.)

As the following chart illustrates, Bernanke has taken Friedman’s warning to heart: The Fed has more than doubled its balance sheet since the financial crisis began, leading to an unprecedented jump in the monetary base:

Thus far, this enormous injection of new reserves into the banking system hasn’t caused the CPI to explode, but that is because (a) the banks are mostly sitting on the new reserves because they are all terrified, and (b) the public’s demand for cash balances has risen sharply. But using very back-of-the-envelope calculations, there is now enough slack in the system so that if banks calmed down and lent out the maximum amount of reserves, the public’s total money stock could increase by a factor of 10. There is no way that the public will simply add that new money to its checking accounts or home safes without increasing their spending. Eventually, prices quoted in U.S. dollars will start shooting upward.

All of the financial analysts are aware of this threat, but they foolishly reassure us, “Bernanke will unwind the Fed’s holdings once the economy improves.” But this commits the same mistake as the Keynesians during the 1970s: What happens when the CPI begins rising several percentage points per month, and unemployment is still in the double digits? What would Bernanke do at that point? Expecting the Fed chief to relinquish his new role of buying hundreds of billions in assets at whim, in the midst of a severe recession, would be akin to hoping that a dictator would end his declaration of “emergency” martial law in the middle of a civil war.

There are even many free market economists who are predicting that the Fed’s massive money-pumping will “fix” the economy, at least for a while, but at the cost of high price inflation. Yet these analysts don’t realize that they are buying into – what we all thought was – the discredited Phillips Curve. The 1970s proved that the Fed cannot fix structural problems with the economy by showering it with new money. Hyper-depression is simply stagflation squared.

People need to stop wondering, “When will the market find its bottom? This month? Next?” The federal government has already done an incalculable amount of damage to the American financial sector, and the insults keep growing. Think of it: Besides the unpredictable “sometimes we seize you, sometimes we take billions of bad assets off your books, sometimes we let you fail” strategy with respect to major financial institutions, the government has also done childish things such as ban short-selling of financial stocks. No one knows what the rules will be next week in these markets. Only a fool would expose new capital to the American financial sector at this point – and the politicians have the gall to wonder, “Why are the laissez-faire credit markets frozen?”

Market interest rates are prices and as such they communicate important information about real, underlying scarcity. When the central banks of the world decided to drive interest rates down to practically zero, they crippled the ability of the world economy to heal itself after the overconsumption of the housing boom. People all over the world need to be saving right now, and yet governments are doing everything they can to squander what’s left of the capital stock.

I had resisted predicting that we are now living through the early period of the Great Depression II. After all, the conventional statistics today are nowhere near as bad as they were in the 1930s. However, the recent tussle over AIG bonus payments convinced me that we are in this one for the long haul. In particular, Senator Charles Schumer’s comments – and the proposed legislation to back them up – show that we no longer have property rights in this country:

“My colleagues and I are sending a letter to [AIG CEO] Mr. Liddy informing him that he can go right ahead and tell these employees that are scheduled to get bonuses that they should voluntarily return them, because if they don’t, we plan to virtually tax all of it. He should tell these employees if they don’t give the money back, we’ll put in place a new law, that will allow us to [tax] these bonuses at a very high rate, so that it’s returned to its rightful owners, the taxpayers. So for those of you who are getting these bonuses, be forewarned: You will not be getting to keep them.”

This is an extremely dangerous precedent. It’s true – as many outraged callers to the AM talk shows explain – AIG received billions in government handouts, and so there is a plausible case to be made that those contractual arrangements with its executives should have been amended. But if that’s the case, then the government should have made that a condition of the original “loan,” or at the very least the government should now exercise its power as the de facto owner of AIG. Liddy was handpicked by the government to run the company, so if the politicians don’t like his decisions, they should fire him.

In contrast, look what Schumer & Co. have done. They are establishing the precedent that if a particular group of rich people does something that angers the government, and if this group happens to be wildly unpopular with the general public, then it is noble for the government to implement ex post facto changes to the tax code, singling this people out and basically robbing them. Schumer’s speech against AIG executives is not much different from him declaring, “So I say to Rush Limbaugh and other talk show hosts: Go ahead and continue preaching your hatred and pessimism about the U.S. economy; this is a free country and you have the right to do that. But be forewarned that we are crafting new legislation that will tax 90 percent of your ad revenues from doing so.”

What people need to realize is that the government is going to keep making this worse. In other words, it is not enough to step back and say, “Well, the feds have already partially nationalized the entire banking system, and brought politics into all major business decisions – including how executives choose to travel to business meetings. What are the effects?” On the contrary, we need to realize that as things continue to deteriorate – and they will – the Obama Administration will keep upping the ante. “What? The first stimulus didn’t work? OK let’s borrow and spend another $1 trillion; maybe that will ‘take.’”

The American people need to prepare themselves for hyper-depression. The future is still uncertain, and if the folks in Washington suddenly found free market religion, that terrible outcome could be avoided. But I’m not holding my breath.

Regards,

Robert Murphy
for The Daily Reckoning

Editor’s Note: Robert P. Murphy has a PhD in economics from NYU and is author of the forthcoming The Politically Incorrect Guide to the Great Depression and the New Deal (Regnery 2009). He runs the blog Free Advice.

The Threat of Hyper-Depression originally appeared in the Daily Reckoning. The Daily Reckoning, offers a uniquely refreshing, perspective on the global economy, investing, gold, stocks and today's markets. Its been called "the most entertaining read of the day."