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Revisionist View of the Great Depression - Part III


The Pharaoh's Treasure
According to the ancient Greek historian Herodotus the treasure of no Egyptian pharaoh was comparable in either size or value to the enormous hoard of Rhampsinitos. His treasury was housed in a huge stone building adjacent to the palace, and it was considered burglar-proof. The door was sealed by the pharaoh's personal seal and manned around the clock by armed guards. Rhampsinitos was present in person every time the seal was broken and the building entered. Therefore it was extremely disturbing when the pharaoh discovered that his treasure was being pilfered, albeit without any sign of unauthorized entry into the building. To find out what was going on the pharaoh caused a trap to be placed inside to catch any would-be thief as he was approaching the treasure-bins. To his utter amazement, on his next visit the pharaoh found that, while the trap had done the job of catching the would-be thief, this did not help him one iota to solve the mystery. More treasure was missing, together with the head of the would-be thief. There was no sign showing how the missing objects had been spirited out of the building. The identity of the thieves could not be established. As if someone had the supernatural power to enter the building invisibly and pilfer the treasure without leaving any trace.

Pilfering the Wealth of Nations
The Great Depression seems to have presented a similar mystery. Productive enterprise came under pressure to liquidate debt and inventory, so excruciating had the debt-burden become. Those firms that could not liquidate fast enough were themselves liquidated. The Wealth of Nations was decimated as scores of firms that still flourished only yesterday were going bankrupt. There was no sign whatever that the loss of wealth might be due to plunder or pilferage. Governments purchased nostrums prescribed by Keynesian and Friedmanite soothsayers to prevent similar disasters from happening in the future in the belief that the destruction of wealth was due to natural causes. But as depression has struck Japan in spite of taking the prescription, and as other countries appear to succumb to the Japanese disease, the peddlers of nostrums are open to charges of being impostors. In the absence of an acceptable theory explaining the Great Depression the danger of future depressions looms larger than ever in the horizon.

Our revisionist view presented here for the first time suggests that, far from being due to natural causes, the Great Depression was unquestionably the result of plunder and pilferage. The Wealth of Nations was being pilfered invisibly. Those responsible couldn't be caught because the thievery involved no physical movement of property. It is no less remarkable that whenever a dead body is found (such as that of LTCM, or that of Enron), the head is missing and the investigation of theft can proceed no further. Public opinion has been lulled into the false belief by the economists' profession and by the financial media that there is in fact no pilferage, and the phenomenon must be explained by the idiosyncracies of the capitalist system of production.

Capital Consumption
It is a daunting task trying to change a consensus that has been nurtured through generations. Yet we must not shrink from exposing the crime if we know who the culprit is, even if we run the risk that our evidence will be laughed out of court. Here is our analysis. The thievery involved no physical transfer of property. It involved book-keeping transfers from the balance sheet of the productive sector to that of the financial sector. The root cause of the wholesale bankruptcy of productive firms was not the falling price structure but the falling interest-rate structure. As interest rates fell, bond prices rose, and with them rose the present value of debt. This caused the cost of servicing productive capital already deployed to rise as well. However, no allowance for increased costs was made in the balance sheet. There was no recognition of the fact that falling interest rates caused the cost of liquidating liabilities to snowball, changing the bottom line of the liability column unilaterally. In other words, there were losses that were never realized and no charges to income against them have been made. As this was the practice across the board, the failure to realize losses in the national economy meant that society has been consuming capital on a grand scale over a long period of time. In the end productive enterprise was operating on the strength of phantom capital. Not only was capital consumption universal affecting all firms engaged in productive enterprise, it was going on unnoticed. The viciousness and violence of the reaction, when it finally came, was unprecedented. Productive firms were falling right and left, regardless of the demand for their products. Firms that were certified as being sound one day would go bankrupt the next. One of the lessons of the Great Depression is that capital consumption is the most treacherous form of credit abuse that may plague society, mainly because it can go on unnoticed for so long before anyone will detect it. Corrective action, when it comes, is too late. This highlights the importance of maintaining the highest accounting standards. Any attempt at compromise is a crime not only against the shareholders, but against society as a whole.

Once we have identified capital consumption as the cause of the Great Depression, the next question is why the rate of interest was falling as long and as much as it did, making the consumption of capital on the grand scale possible. To be sure, without such a prolonged and pronounced fall the consequences of the error of omission to account for losses due to the increase in the cost of liquidation would have been inconsequential. In order to find the reasons for the fall in interest rates we have to refer to chronology. This will establish the direct responsibility of politicians, in particular, the responsibility of one man, F.D. Roosevelt. The banks in the United States lay prostrate between Election Day, November 1932, and Inauguration Day, March 1933. As a consequence of the economic boom of the "roaring twenties" interest rates were steadily rising and bank capital was greatly weakened by the proliferation of non-performing loans. Rumors had it that Roosevelt, the Democratic candidate for the presidency would, in spite of his repeated pledges during the campaign to the contrary, "go off" the gold standard and devalue the dollar. There was a run on the banks. People were withdrawing their savings before the monetary mischief could be sprung upon the nation. They didn't trust the integrity of the banks or that of the politicians — not entirely without reasons, as one might add in retrospect. Some revisionist historians even go as far as suggesting that rumors of devaluation were deliberately planted by Roosevelt himself. He did want the banks to fail so that upon inauguration he could declare a state of emergency and assume dictatorial powers. (Note that these allegations of revisionist historians have no bearing on my argument. Be that as it may, it is a fact that Roosevelt made himself unavailable during the interregnum, and refused to deny the rumors of an imminent devaluation, in spite of repeated appeals from Hoover.)

Wiping out Negative Net Worth
Shortly after inauguration Roosevelt did indeed close the banks. Later most of them were reopened and given a clean bill of health but, in reality, the banks were in a very sorry state rather similar to that of the Japanese banks today. They had a negative net worth. There were huge holes in their balance sheets. They could open for business only by virtue of the government's connivance allowing bank inspectors not to enforce the accounting rule that assets be carried at market value in the balance sheet. The banks had a strategy to wipe out negative net worth by mending the holes in their balance sheet — a Herculean task. On the assumption that interest rates would fall further, they could keep buying government bonds to let capital gains in the bond portfolio take care of capital insufficiency.

There was just one problem with that strategy. It was the risk that interest rates may turn around and start rising. This would not only hurt the banks, it would turn the bond market into a "killing field". Field where the banks would be slaughtered. There were plenty of reasons, too, why interest rates could indeed turn around and start rising again. There was the continuing threat of devaluation of the dollar. There was the added threat of a huge inflation. (In the fullness of times, both threats became a reality.) There was a flight of capital from the country. The banks could not have concocted a riskier strategy to save their skin. But there was a godsend which turned the risky bet into a safe one. The risk threatening the banks' strategy was removed by a Presidential Proclamation.

Save the Banks, Ban Gold
Roosevelt called in gold coinage and then cried down the value of the dollar. He made trading in and owning gold (in forms other than jewelry) a crime. What has all this got to do with the banks' strategy for survival? Here is the connection, which has never been adequately explained by scholarship. The risk that interest rates might turn around and rise, thus frustrating the banks' strategy to wipe out negative net worth, was eliminated by Roosevelt's ban on gold hoarding. The ban had a deflationary effect on the economy as it started a downward spiral in the rate of interest. Before the ban those who wanted to manage their liquid wealth most conservatively would park it in gold. After the ban they were forced to park it in government bonds. The captive clientele for government bonds guaranteed that bond prices would keep rising, and interest rates would keep falling, for several years to come. The banks were given the green light to go ahead with their massive bond-speculation scheme. An orgy of speculation in the bond market followed.

Everybody knows about the bull market in stocks in the 1920's. Reams of books have been written on that subject. But nobody seems to have heard about the bull market in bonds in the 1930's. Yet it is a fact that the volume of the latter surpassed that of the former by a factor of ten. The banks made obscene profits in the form of capital gains in the bond portfolio. For the next six years, while interest rates continued to fall, the banks and other firms in the financial sector got fabulously rich while firms in the productive sector were being put through the wringer. The banks' profits were more than enough to wipe out negative net worth. Banks that had been technically bankrupt at the beginning of the decade were in ultra-strong financial position by the end of the same decade.

Financial Vampirism
The banks' newly found wealth did not come out of nothing. It was not newly created wealth. It was existing wealth that was siphoned off the balance sheet of productive enterprise forcing it into bankruptcy in consequence of this financial vampirism. We must remember that the banks' pilfering the Wealth of Nations was made possible in the first place by the crudest form of government intervention in the market: the confiscation of the people's gold without due process, something the government was not authorized to do under the Constitution. The unconstitutional act was the catalyst to bring about the historic fall in the interest-rate structure. This is not to suggest that Roosevelt was an accomplice or a stooge, nor that he declared his ban on gold hoarding for the purpose of bailing out the banks. It is possible that he had other motifs, and the benefit to the banks was a fortuitous coincidence. We may never know, and it does not matter. The fact remains that tampering with gold is tantamount to tampering with interest rates. It is a most dangerous expedient as it may have many unforeseen and untoward consequences. Far from being a barbarous relic, gold remains firmly implanted at the base of the credit pyramid. Gold has been removed from the economy only in the visionary view of revolutionaries.

This, then, is the revisionist view of the Great Depression. Without the gold ban the recession that started with the 1929 stock market crash would have been over by 1932. With the gold ban, the recession was turned into the greatest depression of all times. The man who was celebrated as savior ridding the nation of the curse of depression was in fact the one who had brought about the disaster in the first place. He pulled the gold trigger releasing the murderous forces of bond speculation to prey upon the productive sector. It heralded the continuing fall of the rate of interest. Bond speculators, first and foremost the banks among them, were ready to move in for the killing. The vultures picked the bones of productive enterprise clean. All this was done under the veil of anonymity. Nobody could have guessed that the Great Depression was a happy time for some. Well, for the bankers it was time for popping corks. Not only was their skin saved, but they became so strong financially that they could thereafter dictate government policy.

Amend the Criminal Code!
The Criminal Code does not deal with theft perpetrated through siphoning off wealth stealthily from someone else's balance sheet through the manipulation of the interest rate structure. This in itself is understandable as it has been drawn up before the techniques of such manipulation were developed. But why has the government failed to amend the Criminal Code to deal with new forms of crime against private property as soon as the new techniques to commit them were developed? Is it pursuant to a pact representing conspiracy between the government and the banking fraternity, the foremost beneficiary of the new forms of crime? Where have the accountants and the economists been to demand a public inquiry into these questions?

There are many cases where the development of technology creates new possibilities to invade and pilfer the property of others in various ways not dealt with by the Criminal Code. All these cases exhaust the common-sense concept of thievery as they are guided by the intention of securing an advantage at the expense of the invaded party. And, indeed, in all these cases the Criminal Code has been amended soon after the new technology to commit the crime of thievery was developed. One example is the invention of saleable electric power. Understandably, the original Criminal Code could not deal with the invisible crime of stealing electric power. The technology of committing the crime was not yet available at the time. Yet soon enough after the introduction of marketing electric power the Criminal Code was amended to cover all new forms of crime connected with the unauthorized tapping of electric power, including the wired and the wireless variety. It is the scandal par excellence of the past century and millennium that no amendment to the Criminal Code has ever been proposed to deal with the biggest invisible crime of all: that of the unauthorized tapping of the balance sheet of productive enterprise — a crime made possible by the destruction of the gold standard and its corollary, the manipulation of interest rates through central-bank open market operations and bond speculation.

Don't Entrust Your Money to Desperadoes
We have seen that the chief culprit and the only beneficiary of the Great Depression was the banking fraternity. They profited from the disaster devastating the world economy. Let's pick up the thread left off in part two, and continue our discourse on the consequences of relaxing accounting standards and allowing illiquid banks to keep their doors open for business. An illiquid bank, by definition, is one that can be considered solvent only by virtue of relaxing accounting standards, allowing the bank to carry an asset (usually a government bond) at acquisition price, regardless how low the current market price of that asset may have fallen. It was a colossal mistake to reclassify insolvent banks as merely 'illiquid' and letting them continue in business. Why? Well, illiquid banks are desperadoes ready to take unreasonable risks with the people's money entrusted to their care. Illiquid banks have nothing to lose but their stigma of being insolvent. They should be closed down by bank inspectors without hesitation. Any compromise in relaxing accounting standards is foolish in the extreme. It invites great dangers affecting not only shareholders and depositors, but society as a whole. It is hard to imagine a dictum more insane than the one: "Bank X is too big to fail". The bigger the insolvent bank, the greater is damage that it will ultimately inflict on the unsuspecting productive sector.

Cui bono?
We have argued that the Great Depression of the 1930's was caused by illiquid banks in the United States as they became the engine of an unprecedented speculative orgy in the bond market in order to drive down interest rates. We could also argue that the present depression in Japan has been caused by the large insolvent Japanese banks as they have become the engine of another enormous bull market in bonds to drive the rate of interest to zero. There is more to this story than revisionist history. Our insight may help explaining the passing scene of our days. The ban on gold hoarding has been replaced by the manipulation of the gold market, possibly with government connivance. In trying to understand an unexpected or puzzling event, historians used to ask the key question: cui bono? (who is the possible beneficiary?)

It ought to be understood well that gold manipulation (i.e., conspiracy to keep the price of gold permanently in a low range) is deflationary. Just as Roosevelt's ban on gold hoarding, the present exercise in gold manipulation also has the effect of restricting demand for physical gold. The result is the same: interest rates keep falling, and for the same reasons. Liquid capital all over the world is seeking out the 'next best' alternative to gold as a conservative investment medium. It will find it in the form of U.S. government bonds. Once more, a captive market for bonds has been created. As the bidding continues, interest rates keep falling. Bond speculators are invited to jump on the bandwagon. The risk that interest rates might turn around and start rising, thereby frustrating the speculation, has been greatly reduced by the gold manipulators. Before our very eyes (and not everyone has eyes to see this sort of thing) there is an orgy of bull-market speculation in bonds. It started twenty years ago. The end may not be in sight yet. In 1980, interest rates in the United States were around 16 percent per annum. They have come down to the level between 4 and 5 percent. If the example of Japan is any guide, they still have a long way to go. American interest rates could follow the Japanese into the abyss. Why not? The mechanism to link the two rates is already in place. It is called the yen-carry trade. The speculator sells the Japanese bond and buys the American. This amounts to borrowing yens at zero percent (or thereabouts), converting the proceeds into dollars and lending them at 5 percent. The reward? Almost 5 percent — not bad for shuffling paper. Clearly, the effect of the yen-carry trade is to drive down the rate of interest in America, too.

The consequences of a falling interest-rate structure today are no different from those in the 1930's. There is capital consumption in the productive sector. There is a clandestine transfer of wealth from the productive to the financial sector. Cui bono? Why, for the benefit of the banks, of course. American and Japanese banks. Banks of any stripe or color. The worst part of it all is that the public is still in the dark about the invidious consequences of falling interest rates. It is being told a tale about free markets deciding bond values and the value of gold. The ominous fact, however, is that both markets are rigged to the core. They are like a casino where the dice are loaded for the benefit of the house.

$100 trillion worth of hot air
The truth is that there is no public benefit in bond, foreign exchange, and gold speculation. None whatsoever. The world could still go on without any of this trading, and no one would be any worse off. The overwhelming majority of the people, including all savers and producers, would be better off. Interest and foreign exchange rates were so stable under the regime of the gold standard that no speculator in his right mind would hold bonds or foreign exchange in the hope of speculative gain. Not only do we have speculation in bonds and foreign exchange, we have also allowed speculators to construct derivatives markets on the top of the bond, foreign exchange, and gold markets. Since 1971, the combined volume of derivatives has snowballed as it has hit and surpassed the $100 trillion mark! No misprint here. There is commitment to pay compensation for the fluctuation in the value of $100 trillion worth of paper. (Never mind that there isn't as much paper in existence, not even if we include the scum of the junk bond market.) For centuries before 1971, the grand total of paper so 'insured' was exactly zero. To put it differently, in 1971 the world all of a sudden developed an insatiable appetite for insurance. In thirty years the world has come up with $100 trillion worth of 'insurables' to bolster security. What security? Maybe financial security? No, we can't very well say that, not after the collapse of Enron, and not after the dollar having lost an unprecedented 90 percent of its purchasing power during the same thirty years. Then physical security, perhaps? No, not physical security. Not after the destruction of the twin towers of the World Trade Center, and not in the middle of a drama in two acts, the oil war against Iraq. Then what kind of security is it that the insuring of $100 trillion represents? Search as you may, you will find but hot air. The world was a much better and safer place for hundreds of years with stable interest and foreign exchange rates, and with a stable gold price, and without any insurance on hot air. Had it kept them that way, it could have earmarked funds for the eradication of poverty, hunger, diseases, illiteracy, or for any other noble cause.

The $100 trillion dollar market in derivatives created by the big American and Japanese banks serves no purpose consonant with the interest of the national or world economy. It serves one purpose only: the aggrandizement of the profits of the financial sector at the expense of the productive sector. The big American banks were as insolvent twenty years ago as the Japanese banks are today. Then they started their desperate bond-market gamble, trying to drive down interest rates. They badly needed capital gains in their bond portfolio to mend the enormous holes in their balance sheets. The gamble has paid off. Today the American banks are in a better financial shape than twenty years ago. However, a high price for saving their skin was paid by the productive sector. American firms producing hardware have been put out of business. Solid jobs in the productive sector were eliminated and replaced by soft jobs in the service sector. The plight of the American breadwinner who is now flipping hamburgers instead of pouring molten steel (and who may soon be out of any job) is in direct consequence of the orgy in bond speculation. Nor is this all. The depression in Japan may not stop at the Pacific. It may well portend to engulf America and the rest of the world.

Bond Speculation is No Zero-Sum Game
I am well aware that the sum $100 trillion is a 'notional' amount. We are not talking about $100 trillion worth of bonds being traded. We are talking about the combined stakes of bond speculators who have placed bets on the rate of interest, and want to profit as if they have owned bonds in that amount. But the profits, provided the speculators' bet comes off, are not 'notional'. They are payable in cold cash. Suppose for the sake of argument that these bets call for lower interest rates on a net basis. In other words, most speculators would be buyers of bonds as they expect their value to rise further. (This is a plausible assumption. No doubt this is exactly what Japanese banks scrambling to get out of bankruptcy are likely to be doing right now.) If interest rates did in fact go down and the price of bonds did go up, say 1 percent, then the speculators' profit would be $ 1 trillion in cash. Who is going to pay that?

Economists will tell you that the profit of one speculator is the loss of another. Don't buy that. It is arrant nonsense. It would be true only if bond speculation were a zero-sum game, which it is not. It would be true only for stabilizing speculation dealing with risks created by nature, for example, in the futures markets for agricultural commodities. Here speculators make money by resisting the formation of price trends. As there can be no consensus about the question whether the formation of an uptrend or a downtrend is more likely, speculators will be betting on either side of the market. But in markets where risks are man-made, speculation is not a zero-sum game. This is the case of destabilizing speculation. In the market for bonds and its derivatives speculators make money by inducing and then riding price trends. They are on the same side of the market (which is practically always the winning side). Remember, speculators can influence the outcome by throwing their weight around. (Try to do that against the blind forces of nature!)

Why are the risks in the bond market man-made? Because under the gold standard interest rates were stable. There was little risk that bond values might change abruptly. Risks were injected artificially when politicians forcibly removed the gold standard.

But if the gains of one bond speculator is not paid by another, then who is paying it? This is a crucial question that deserves a careful answer. The other side of the bet of the bull speculator in bonds was taken by a banker for hedging rather than speculative purposes. He sold the bond in order to hedge his exposure in lending money to productive enterprise. He is not betting: he is taking out insurance, as it were, against the risk that interest rates might rise before his loan matures. With regard to the bond market, his position is neutral. He has a straddle: the loss on one leg is canceled out by the gain on the other. The loss connected with falling interest rates is passed on to the party on the other side of the hedging banker's straddle. Therefore, ultimately, the losers paying the $ 1 trillion profit to bond speculators are the firms in the productive sector. They are sitting ducks in this speculative game. They have no choice. They must carry the risk of owning productive capital, without which there will be no consumer goods for you, for me, or for any other member of society. The foregoing argument is a convincing demonstration of the mechanism whereby the capital of the productive sector is surreptitiously siphoned off to benefit the financial sector, as speculators drive down the rate of interest to zero. Producing firms are condemned to bankruptcy for the benefit of parasites. This is the essence of depressions.

Monument to Folly
The $100 trillion derivatives market is a monument to the folly of man. Derivatives trading serves no purpose other than benefiting a parasitic class, that of the bond speculators, first and foremost the banking fraternity, at the expense of the productive sector. Producers meekly accept their role of sacrificial lamb. They do so because they lack understanding of what is happening to them, just as lambs herded in the slaughterhouse do.

This exposes the enormity of the folly of having destroyed the gold standard, cutting the interest-rate structure adrift. Thereafter bond speculators would, whenever the opportunity presented itself, drive down the rate of interest all the way to zero while, in the best tradition of vampires, they suck the life-blood out of the producers. The opportunity first presented itself in 1933 when Roosevelt banned gold hoarding, making the one-sided speculation in bonds possible. A new opportunity seems to present itself right now, as a result of a new phenomenon, the gold-carry trade. Its real purpose is not so much the capping of the gold price as the making the one-sided bond speculation possible once more. Thus the gold-manipulation scheme serves as a foundation for the $100 trillion monument. This ought to be our reminder that bond speculators are hell-bent to plunge the world into a depression once again, as they did in the earlier episode.

Unless governments can muster their brain- and will-power, demolish that monument, stop the deadly game, and stabilize interest rates once more by opening the Mint to gold.

—  This paper is based on a series of talks with the same title givenby the author at Sapientia University, Kolozsvár (Cluj-Napoca), Romania,in April, 2002.

—  Benjamin M. Anderson, The Financial History of the United States(originally published in 1949), Liberty Press, Minneapolis
—  A. E. Fekete, Kondratieff Revisited, March 2001, www.gold-eagle.com/editorials
—  A. E. Fekete, TheEconomic Consequences of Mr. Greenspan, December 2001

Revisionist View of the Great Depression - Part I - SPECULATIVE ORGY IN BONDS

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