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The deflation of the Great Depression and the ensuing unemployment resulted in the election of the dictator FDR, the destruction of the old republic, and creation of the modern American civil service mega-state. If you could go back in time, and put yourself at the head of the Federal Reserve in 1930, would do you anything differently?



you've got some reading to do. America's Great Depression http://mises.org/rothbard/agd.pdf


I've read it. Rothbard is dead right about the dangers of fractional reserve and the need to avoid inflation in the first place. But he's dead wrong about what to do once the crisis hits. I do not buy his arguments that Hoover's actions after the crisis caused the severity of the downturn. It's very unlikely that Hoover's cajoling was the cause of sticky wages. Right now we are seeing businesses across the economy choose layoffs rather than wage cuts, even in non-union, non-regulated sectors like tech. Furthermore, the major cause of the unemployment was businesses going bankrupt. Businesses went bankrupt because when the money supply shrank they could no longer payoff their debts. The debts were all nominated assuming a much greater money supply. Deflation caused the unemployment.


wow. you're the first person I've run into who has a strong grasp of the facts. I would argue that debts nominated during a time of a much larger money supply led to businesses that were predicated on artificial demand. when the demand shrunk these businesses went bottom up. The great depression is an almost perfect example of economic latency. Those workers did eventually get assimilated back into productive industry, it just took a long time.


The demand was not artificial. For example, before the crash people bought a lot of cars. After the recovery, people bought even more cars. So why was it necessary to go through 5-10 years where nobody made or bought cars, factories sat idle, and laid off autoworkers went hungry? There are cases in recessions where the unemployment is beneficial. For instance, "financial instruments" have been overproduced, and it would be beneficial for Wall St. workers to be laid off and then find more useful jobs. But a depression is marked by lots of collateral damage - people get laid off in industries simply because of instability in the banking and moneterary system, not because they were not being productive.

Let me ask this question: Imagine a gang of thieves slowly slipped counterfeit bills into the money supply for a long period of time. Eventually, half the money supply was counterfeit bills. The thieves had long traded their counterfeit bills for wine and women. The bills were now evenly distributed across the economy, in every home and business. Suddenly, the crime is discovered. Now no one will except the counterfeit bills. The money supply drops in half. Businesses with debt and wage contracts created before the counterfeit money was discovered start to bleed red ink.

What is the proper policy response to this scenario?


I am not sure of the answer you are expecting to your question. Or if you expect one at all. Here's my amateur take.

One way is to do nothing and let the chips fall. I imagine this as the economic equivalent of a broken chain in the anchor room of a battleship. Disorderly with lots of collateral damage, wailing, and gnashing of teeth.

There is the Andrew Mellon approach to "liquidate! liquidate! liquidate!" the misallocated capital and redeploy as quickly as possible. This means accepting that some portion of the productive capacity at peak monetary supply was based on phantom demand and it needs to be torn down and converted to something productive that will have real demand going forward. Yes, a whole lot of hard-working folks literally wasted years of their lives. I don't know what the collateral damage would be -- probably nasty. This is actually the function of recessions, and a fierce but orderly unwind with social support for the displaced would seem preferable to the constant terror and confusion of attempting to delay the inevitable liquidation and redeployment.

Another option is the path we are taking (I say 'we' grudgingly because I disagree, but I am a passenger aboard the United States of Titanic). Attempt to keep the monetary base stable, even though half of it is based on phantom demand. 'Legitimately counterfeit' the balance, theoretically giving businesses and individuals enough cover to pay down debts and become net savers again, then wind down the monetary base to equilibrium. This really hasn't worked for Japan. I'm just speculating...without a market incentive to liquidate and redeploy capital don't we just end up with zombie industries serving the same old phantom demand? Everyone has a job building shit nobody needs, and nobody has a job building shit everyone needs. The remaining productive industries get crushed under the tax burden of supporting the zombies, until it all ends in tears and there is nothing left to redeploy anyway ('Ayn Rand Endgame', anyone?).

There is no policy cure for massive fraud and theft. Neither is the tinfoilers' favorite a cure: 'gold-backed non-fractional banking'. There is no magic economic triple antibiotic that will make the owie go away. There is only facing the truth -- you got duped -- excluding those responsible from society, and directing our future efforts to things that actually raise our standard of living (I may be biased, but to me this means technological increments that help us use our limited energy more efficiently).


There is no policy cure for massive fraud and theft.

this is the best one liner on the economic crisis I've ever seen. Pundits should be paying you to write.


See my response to nazgulnarsil below.


the greater consumption of cars in the years following the great depression were due to having suppressed demand for all those years. as for the scenario you seem to be saying that the government needs to step in and take up the role of the counterfeiters. Why should the supply and demand structure from the time of counterfeiting continue on? those demands were artificial and the market met those demands with artificially inflated supply.


Let's say that in the counterfeiting example, the counterfeiters pumped $300 billion a year of counterfeit bills into the economy. The counterfeiters spend all this money on wine and women.

When the counterfeiters are found out, this $300 billion dollars of demand for the vineyard and brothel industry evaporates. That will cause much unemployment. I agree with you that this should be allowed to happen. The workers in those industries must find new jobs that are economically productive. The government should not step in and start printing money to prop the brothels up, as this will simply create zombie industries as Giles noted. (Nor can the Giles recover the lost wealth - the counterfeiters already spent the money, the resources that went into producing the wine and woman have been consumed).

But there is a second cause of unemployment, which is the unnecessary collateral damage caused by the deflation. When half of the money supply evaporates, people's savings to expenses ratio are now at dangerously low levels. So they start reining in expenses. But all expenditures are another person's income, so business revenues fall. In theory, the businesses could drop their wages and prices an equivalent amount, and eventually you would get a pigovian rebalancing effect. But the trouble is sticky labor and, more importantly, debt contracts. When revenues fall, the businesses cannot pay debts, they go bankrupt, people are unemployed, and you get a full fledged deflationary spiral. Millions go unemployed, not because they were not building something people wanted (they were), but simply because contracts rely on a steady money supply, and when money supply drops by 50%, all contracts get shot to hell.

There are two solutions: one, the government could announce that in light of the discovery of the counterfeit bills, all contracts will be redenominated at a 2:1 ratio - thus debt contracts will be cut in half, wage contracts cut in half, NFL salary cap cut in half, leases cut in half, etc. Or, the government could announce a one month window in which people can trade in their counterfeit bills for real ones. This will restore the money supply to the original levels. Either one of these solves the problem instantly and completely avoids the depression. There are no zombie industries, everyone just continues with their productive pursuits. The only unemployed people are at the vineyards and brothels, they must still find new jobs.

Of course, if the government decides to restore the money supply by printing money and giving it to government workers digging ditches, then you will still get massive frictional unemployment, and you'll permanently reallocate resources into useless activities. This is the Keynesian/Obama solution and it's a terrible one.

The problem you, Giles, and the Austrians have is that you do not distinguish the unemployment caused by necessary restructuring ( the brothels and vineyards) from the unemployment caused by a fall in the money supply and the wrecking of contracts. The first cannot and should not be avoided. But you can, and should, prevent the collateral damage that creates a great depression. Until you see the difference between these two types of unemployment, you guys will get killed in debates with the Keynesians, and no one will listen to you. Which is too bad because the Austrians have a lot of great insights, and the Keynesians are awful on a lot of other points.


I see your point about unemployment, but I'm going to play the devil's advocate for a moment anyway.

I didn't distinguish between causes of unemployment in my post because the market doesn't care. Does it?

"all expenditures are another person's income"; We agree here. It is unlikely that the 1/2 of the economy previously paid for in counterfeit bills was all wine and women. The money they earn is spent and flows into other parts of the economy, creating phantom demand in, effectively, all sectors.

A properly functioning market, by definition, knows how to trim the phantom demand from all sectors immediately and reallocate the remaining capital. This is the path of least collateral damage. Government distortion of the market process (in the form of monetary policy and failure to universally enforce existing laws) prevents market participants from perceiving that which will have value going forward from that which will not; when that happens, the only self-preserving course of action available to an individual investor is to take his or her money and go home until the smoke clears. That disorderly pseudo-market behavior is what really causes most of the deflationary collateral damage, because even the most solid players in the strongest sectors get torched.

Read that again -- compare it to the market behavior the past few months. That is the part of the spiral we're in. Until the government enforces existing laws universally and removes it's monetary distortions from the markets, private capital will stay in the proverbial mattress -- which makes all this Keynesian-vs-Austrian monetary policy talk into just a bunch of masturbation.


* The money they earn is spent and flows into other parts of the economy, creating phantom demand in, effectively, all sectors.*

No, only the money spent near the entry point into the market is distortionary. The counterfeit money that was created five, ten, twenty years ago, acts like any other money. Think of it this way, imagine the counterfeiting had stopped fifty years ago, but the counterfeit bills had remained circulating for all that time. Are they causing distortions? No they are not, at this point they are just like any other bill. Likewise, if you are on a gold standard, it does not matter whether the gold was original stolen from the Incans hundreds a year ago. Once it's in circulation for a while, its origins do not cause distortions.

Or think of it another way. The vineyard and brothel workers spend their counterfeit bills on food, rent, and movies. Let's say the inflation stops. Now, seniors with savings have more money to spend, since they are not losing money to inflation each year. So they spend more on travel and nursing homes. The brothel workers now find jobs on airlines and in nursing homes. What do they spend their wages on? Food, rent, and movies. Thus the demand for food, rent and movies was perfectly real. Only the demand for brothels and vineyards was false.

A properly functioning market, by definition, knows how to trim the phantom demand from all sectors immediately and reallocate the remaining capital. This is the path of least collateral damage.

This is simply not true. Remember, the government already injected itself in the free the market when it declared Federal Reserve Notes as the standard fiat currency across the land. Every market contract is written assuming there are are $10 trillion Federal Reserve Notes in the world. Every entrepreneur assumed $10 trillion in notes when they planned their years production. Thus when the Federal Reserve allows the money to supply to drop in half, it is creating a tsunami sized market cataclysm. Like it or not, the government instituted fiat currency many years ago. It made a promise to the market that it would not allow hyperdeflation or hyperinflation. This is not only a promise, it's also good policy. If you are going to run a fiat currency, you should keep your dollars like gold - make the quantity as stable as possible. The market wrote its contracts based on that promise. The government needs to keep its promise, otherwise it will throw the markets into chaos as every contract gets totally fubarred.

That is the part of the spiral we're in. Until the government enforces existing laws universally and removes it's monetary distortions from the markets, private capital will stay in the proverbial mattress -- which makes all this Keynesian-vs-Austrian monetary policy talk into just a bunch of masturbation.

You are simply wrong on the facts. Much of the private capital as simply evaporated. People refuse to trade their dollars for stocks or bonds because in a massive deflation stocks and bonds are bad bet. Dividends are falling, companies failing, bonds are defaulting.

The basic problem is that there only $2 trillion actual Federal Reserve Notes in the world, but before the crisis there were $100 trillion assets in the world. The is an extraordinaryly high ratio. The only reason this ratio got to this point is through a lot formal asset guarantees ( FDIC, treasuries ) and informal guarantees ( Greenspan put, "too big to fail", government encouragement of 401ks, FreddieMac, subsidized loans for homeowners, being complicit as regulated funds put money into AAA bonds, etc,etc). Essentially, the government was winking and nodding as Wall St. pumped counterfeit bills into the economy. When Lehman failed, the government basically said, "Actually, these counterfeit bills are not tradable for Federal Reserve Notes." Then there was a panic as everyone dumped their money market funds and stocks in order to get their hands on FRN's, treasuries and FDIC insured bank notes. The Federal Reserve saw the panic, realized that this could cause cataclysmic deflation, and started guaranteeing assets.

Now, I do not approve of a lot of the government's policy. The "stimulus" is awful. I think they should also stop propping up zombie banks. Home prices need to fall, GM needs to renegotiate its obligations. What the government should be doing is preventing deflation in the most non-distortionary ways possible, such as back stopping the money market funds, declaring a payroll tax holiday and funding it with printed money, or even just mailing every American some newly printed bills. Or if you want to do a clean reboot of the whole thing once and for all, you could try Plan Moldbug: http://unqualified-reservations.blogspot.com/2009/01/gentle-...

If you were running the Fed, you would you remove the backstop on the money market funds? Why? What do you think would happen if you did?


Once it's in circulation for a while, its origins do not cause distortions.

yes it does. paper money is an artificial commodity. its value is a function of how much is available. While the origins of any ONE particular dollar does not matter, the total amount does.

Thus the demand for food, rent and movies was perfectly real.

right, but this demand was only satisfied through the non-productive counterfeiting of money. thus supply was increased without proper cause. The proper cause of higher supply is higher productive demand.

Every market contract is written assuming there are are $10 trillion Federal Reserve Notes in the world.

actually every contract is written assuming that the currency will continue to inflate at more or less the same rate as it has historically.

companies failing

where is the evidence that financially prudent companies are failing? it is only because GAAP are so biased that people are allowed to run companies so close to the wire. Companies with decent cash flow are just fine. Expecting that companies with poor cash flow are healthy companies just because they were able to survive in a time of easy credit has warped perceptions. We will now be forced to return to good business practices. This is a good thing.

What you're talking about is the problem of unwinding all these leveraged positions. No, I don't think people deserve to have their positions rescued just because they didnt understand what leverage meant. No financially prudent company would do ongoing deals with a company that was leveraged 30 to 1.

The whole world has forgotten how to run a business in the absence of easy money. It's time we remembered.

Solid cash flow. Not dependent. Produces something of value.


you're assuming that the government must step in to renominate those debt contracts. consider this: you're an economic agent owed a debt when this happens. Your debtor gives you two options: 1) you hold them to their original contract, they default, you get nothing. OR 2) you renegotiate and at least get some of your money.

part of the problem with the current crisis is indeed "stickiness". That is, people refusing to renegotiate. Why should we reward such behavior?


The "stickiness" is not a result of stubbornness, its a result of how the deflation cascades through the economy. Let's make the scenario even more clean. Imagine overnight a virus runs through computers of the banking system, switches the furthest one to a zero in everyone's account, and thus cuts everyone's savings in half.

The next morning, everyone wakes up, realizes that that their savings is much lower, and that they therefore must cut back on expenses. But they won't cut evenly across the board. They will cut spending on cars, hdtv's, and travel. They'll spend roughly the same amount as always on rice, eggs, water, gasoline to get to work, trash pickup, etc. The manufacturing companies respond by laying off millions of workers. Some of the companies go out of business. As the unemployment rate rises, it puts downward pressure on the wages in the sectors that are still producing at full capacity. This results in wages gradually coming down. As wages come down, the price of products come down. As the price of products come down, people now have money for luxuries. Entrepreneurs buy up the factories and restart car production. Eventually the system rebalances. At the end up the reblancing, the structure of production is the exact same as the structure before the crisis. The only difference is that the price of everything from cars to wages will have dropped to 1/2 the original level.

The government can avoid the whole mess, the whole two or three year cycle of unemployment, by just flipping the bit back and restoring everyone's account to the original level. To not do so, and force the economy through wrenching liquidation and layoffs, would be insane.

Ordinarily, I do not believe the government should rewrite contracts. Nor am I a fan of fiat currencies. But we have a world of fiat currency. And in a fiat currency, the government has a responsibility to prevent a hyperinflation or a hyperinflation. And if the government has been complicit for decades while counterfeit bills circulate through the economy, and all the contracts, business plans, personal budgets, etc depend on those counterfeit bills being tradable, 1 for 1, with federal reserve notes, than the government should do the right thing and allow people to trade in their counterfeit notes for FRN's, rather than allowing a catastrophic deflation to tear through the economy.


a crisis like this can't exist in a vacuum. dumping money on an economy doesn't magically making people's labor less valuable, neither does disappearing a bunch of money. the only reason it has an effect is because of aforementioned stickiness. labor values are relative to one another not absolute.

then you identify the root cause but shy away from it. how would this crisis happen without fiat money in the first place? large amounts of some commodity with inelastic demand would have to be dumped on the market at once (or taken away).


Fiat currency is the cause of the problem, but it also provides the solution. I agree that our financial system should be running MacOS, not windows. I agree that running Windows is why we get so many bugs and viruses. But as long as we are running Windows we should still apply the patches that Microsoft sends us. Or in this case Bagehot. And declaring that we should just let the virus wipe out our computers, so then we can all buy Macs, is neither an effective strategy for making friends and influencing people, nor is it in your interest.

If you're going to run a fiat currency, try and keep it as close to gold-like as possible. Do not inflate, do not deflate. If bug in the banking system wipes out half the currency in the world, simply run a patch to add the money back. If you find some alchemist created gold in a laboratory and pushed it into the market, you should shut down the alchemists lab, but allow the gold that has already entered circulation to continue circulating.


the best way to make fiat currency like gold would be to stop inflating entirely, print no more dollars. the whole point of gold is that supply is relatively INelastic. That is it does not respond to fluctuations in demand. This is what leads to stability, stability leads to confidence about investing for the future.

we inflate every year.




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