Now and Then

Without a doubt, recent government efforts meant to reduce the effects of the financial crisis often seem inaccessible and arcane. Much of the recent debate has focused on things like "bailouts," "backdoor loans" and "quantitative easing. While we deal with the efforts of an interventionist Fed today, we can take a lot about previous efforts during financial panics.

Liaquat Ahamed's Lords of Finance, the story of the key central bankers during the interwar period, obviously deals with these issues extensively. Two stand out: efforts to stem the banking panic (today's TARP and bailouts) and the decision to abandon the gold standard (similar to today's lax monetary policy at the Fed). The latter was the most important pieces of monetary policy in the first half of the Twentieth Century. There were many efforts to mitigate the effects of the depression in the US, but none were as effective. As Ahmad writes, monetary easing was "one step that succeeded beyond anyone's wildest expectations in getting the economy moving again."

Efforts to stem the banking crisis were also eerily similar to the Fed's response to the collapse of Bear, Lehman and the rest of the American financial system. How did it happen back then? Roosevelt had four brilliant young economic advisers during his first term: Dean Acheson, undersecretary of the Treasury, James Warburg, Roosevelt's direct adviser on economics, Lewis Douglas, the budget director, and George L. Harrison, the head of the New York Fed. These men were instrumental in the first maneuvers that Roosevelt conducted to save America's banking system, which was on the verge of collapse. Something like 7000 banks failed between 1931 and 1933, the New York Fed ran out of gold reserves supporting the system (it lost $350 million dollars on March 3, 1932), and almost half of the currency in circulation was withdrawn from banks. In a span of eight days, they stopped this cascading disaster right in its tracks. Hoover had been trying to do it for three years already.

I'll let Ahamed take it from here:

Every one of Roosevelt's advisers, including Harrison, believed that having stabilized the banking system, they could rely on the traditional levers - expanding credit, undertaking open market operations - to get the economy moving again. Most important, none of them could see any reason for breaking with gold.

note: This means abandoning the gold standard and devaluing America's currency. This would create inflationary pressure in the US, as foreigners could buy American goods at a lower price - in their currency - and Americans would have a harder time importing goods. This increase in demand for American currency leads to inflation, which is a good thing when a country has high unemployment and depressed aggregate demand.

Pitted against this array of economic expertise was one man - the president himself. Roosevelt did not even pretend to grasp fully the subtleties of international finance; but unlike Churchill, he refused to allow himself to be in the let bit intimidated by the subject's technicalities - when told by one of his advisers that something was impossible, his response was "Poppycock!" Instead, he approached the subject with a sort of casual insouciance that his economic advisers found unnerving but which nevertheless allowed him to cut through the complications and go to the heart of the matter.

His simplistic view was that since the Depression had been associated with falling prices, recovery could only come about when prices began going the other way. His advisers patiently tried to explain to him that he had the causality backward – that rising prices would be the result of recovery, not its cause. They were themselves only half right. For in an economy where everything is connected, there is often no clear distinction between cause and effect. True, in the initial stages of the Depression the collapse in economic activity had driven prices downward. But once in motion, falling prices created their own dynamic. By raising the real cost of borrowing, they had discouraged investment and thus caused economic activity to weaken further. Effect became cause and cause became effect. Roosevelt would have been unable to articulate all the linkages very clearly. But he had an intuitive understanding that the key was to reverse the process of deflation and kept insisting that the solution to the Depression was to get prices moving upward.

Roosevelt ended up adopting a policy on gold similar to the research of George Warren, a Cornell economics professor who was an expert on farming. And the actual mechanism for accomplishing this was through a farming bill, with an amendment that most people overlooked. It was a reckless and foolish decision that appalled most of the people working for him and caused outrage among the world’s financial experts. But, as Russell Leffingwell, a Morgan partner, wrote to Roosevelt, “your action in going off gold saved the country from complete collapse.”

Days after Roosevelt's decision, the Dow jumped 15 percent, one of the highest increases in its history. During the following three months, wholesale prices jumped by 45 percent and stock prices doubled. With prices rising, the real cost of borrowing money plummeted. New orders for heavy machinery soared by 100 percent, auto sales doubled, and overall industrial production shot up 50 percent.

This is exactly what should have happened if the stimulus had any real teeth. We are where we are because of a true lack of guts. Roosevelt may have been insane for doing what he did, but his hard-headedness and iron cajones prove why he is a true American hero.