Debt, Crisis and Recovery: The 1930's and the 1990's

The 1930's and the 1990's

Albert G. Hart, Perry G. Mehrling

• Publisher: Routledge
• Year: 2016
• Print ISBN: 9781563246388
• eBook ISBN: 9781315286037
• Topic: Business
• Subtopic: Business General
• Index: Business

This book provides a perspective by a prominent economist on the problems of debt, recession, and recovery in the 1930s as compared with the 1990s. The book begins with several chapters on the explosion of debt in the public and private sectors during the 1970s and 1980s, and its implications for economic stagnation and recession that seem to plague the economy. Resolution of the debt problem and reform of the banking and financial system are critically important because these problems dampen economic recovery and growth in the future. The second part of the book is a reprint of Albert Hart's classic 1938 study, Debts and Recovery 1929 to 1937, originally published by the 20th Century Fund. The extraordinary parallel between financial problems of the 1930s and the 1990s, solutions of the past, and proposed reforms for the future may provide a fascinating study for scholars and interested citizens alike.

Part I
Debt, Crisis, and Recovery Revisited

Chapter 1
Debts and Fluctuation

THE ANALYSIS underlying the 1938 edition of Debts and Recovery was based on a mixture of the ideas of Ralph Hawtrey and Joseph Schumpeter, who offered the most advanced theories of money and business cycles of the time. For understanding debt problems, the most important idea in Hawtrey's monetary theory concerned the inherent instability of credit. Hawtrey taught that any disturbance to the economy tends to be magnified by the credit system. Economic upturns tend to turn into cumulative and even runaway booms as credit expansion begets further credit expansion, while economic downturns tend to turn into cumulative depressions as credit contraction begets further credit contraction. Hawtrey sought to understand the workings of the cumulative process in order to guide timely central bank intervention to prevent that process from developing an unstoppable force.

The most important idea in Schumpeter's theory was that industrial fluctuation should be understood as the process by which the economy adapts itself to technological change. In addition to the high-frequency inventory cycles (for which Hawtrey's theory had been designed), Schumpeter identified medium-term fluctuations (Juglar cycles of ten years) and longer-term fluctuations (Kondratieff cycles of fifty years or more). In Schumpeter's view, the longer Kondratieff cycles were driven by waves of innovation in products and processes based on major scientific and technical discoveries, while the medium-term Juglar cycles were driven by stages in the working out of major innovations. He emphasized that the credit system plays a vital role in the longer-term fluctuations because it is credit that allows entrepreneurs to bid resources away from existing uses into new more productive employments. Like Hawtrey, Schumpeter viewed credit as a force of instability but, unlike Hawtrey, he welcomed that instability as the mechanism through which the economy constantly transforms itself.

With these two somewhat contradictory ideas, my generation of economists sought to understand the collapse of the 1930s. From Hawtrey we learned to view the period as a cumulative process which had developed a dynamic force unstoppable by conventional monetary measures. From Schumpeter we learned to view the period as the trough of a technologically driven Kondratieff cycle. While both views captured genuine aspects of the situation, they both also failed to provide much guidance on a way out of the mess in which we found ourselves. Federal Reserve officials tried to develop a practical guide for monetary policy from economic theory by distinguishing between speculative and productive credit, essentially an attempt to distinguish the Hawtreyan from the Schumpeterian aspects of a given situation. But the boom and collapse of the 1920s and 1930s showed the futility of such a distinction. Because capitalist production inevitably has a speculative element, it is not possible to separate the good production from the bad speculation, either during the boom or during the collapse. The failure of a monetary policy to stem the collapse caused most economists to look elsewhere for a tool of policy. The eager embrace of Keynesian ideas after the 1936 publication of his General Theory was in part a consequence of the theoretical and policy vacuum of the 1930s.

Debts and Recovery was an attempt to fill that same vacuum in a somewhat different way with proposals for fundamental institutional reform. Unlike Keynes' book, D&R did not pose as a revolution in economic theory. Indeed the theoretical structure underlying the book was quite continuous with the past. The point was to use the older theory to broaden out from the narrow monetary aspects of the problem to the wider financial system. Where Keynes (or at any rate some Keynesians) counterposed aggregative fiscal policy to the failed aggregative monetary policy of the past, we sought the origins of the failed monetary policy in an inadequate financial structure. Today, when aggregative fiscal policy has itself fallen into disfavor, it may be appropriate to revisit the ideas lying behind the analysis in Debts and Recovery.

DEBTS AND FLUCTUATION

For understanding financial instability, it is important to start from the fact that bank lending creates money. When a loan is agreed upon between bank A and customer X, two pieces of paper are exchanged across the desk. X hands the loan officer a signed promissory note, and the loan officer hands X a deposit slip. No other customer's balance is reduced because customer X has taken out a loan. X's new funds are an addition to the total of deposit balances that would otherwise be in the bank. Money is created also when the bank buys on the market a piece of commercial paper, a government security, or a physical asset such as a new headquarters building. Even to buy stationery or to pay for employees' services is money-creating. Looking in the opposite direction, money is retired from circulation when a bank collects principal or interest on an outstanding loan, sells a security, or charges a fee for services.

Why is this important? When banks create money by making loans, they grant to borrowers the power to make purchases. The ability of borrowers to obtain goods in exchange for their own IOUs is generally limited by the willingness of their suppliers to extend trade credit. However, once their IOUs have been accepted by a bank, so that the bank guarantees payment, they become widely acceptable. In effect, that is just what happens when borrowers take out bank loans. Rather than offering their own promissory notes in exchange for goods, borrowers in effect discount the notes at a bank and offer the bank's promissory notes instead. The key point is that, because banks have the power to endorse certain IOUs and reject others, they have the power to influence the future direction of economic activity. A potential borrower comes to the bank with a business plan. If the bank accepts it, the plan goes forward, where it may fail or succeed. Banks cannot make dreams a reality, but they can, by endorsing certain dreams rather than others, give them a chance to become reality. Endorsing certain dreams about the future and rejecting others, bankers are a force regulating the direction and intensity of economic activity.

Bank credit is therefore always a vital component of business expansions, particularly so in the interwar period when banks were the only significant institutions providing credit. It must be emphasized, however, that the character of the expansion depends on how new loans are ultimately funded. A bank makes purchasing power available by money creation, but that does not necessarily mean that the new loan is ultimately funded by a permanent increase in deposit-holding. Banks may sell the loan directly to an investor, taking a fee for loan origination and continued service. In this case, the newly created money is retired as soon as it has done its job and the bank may legitimately claim that all it has done is to channel investable funds from savers to investors. In this way it is possible to have an expansion of credit without an expansion of money.

However, new credit typically is at least partially funded by an expansion of money because money is typically the low-cost source of funds. (It is this fact that explains the dynamic in our financial system toward the creation of new forms of money and money substitutes.) The reason is that wealthholders are typically willing to forgo some interest in order to enjoy the liquidity services that money provides. The key point is that, by funding loans with money, bankers in effect bridge contradictory views about the future. Bank assets reflect borrower optimism about the future, while bank liabilities reflect wealthholder conservatism. The institution of banking allows optimists to act on their optimism while providing for pessimists the comforting illusion of liquidity.

So long as expectations about the future are sufficiently divergent, it is possible for bankers to balance the hopes of borrowers against the fears of lenders, and in so doing to regulate the pattern and pace of economic activity. The balancing act fails, however, in a general wave of optimism or pessimism, and this is the source of the inherent instability of credit. In a general wave of optimism, borrowers find they can attract funds from wealthholders directly without the mediation of banks, so the ability of banks to control the flow of credit is limited by competition with the capital market as a source of funds. It is not that bankers necessarily get swept up in a general euphoria, but rather that their efforts to act as "pessimists of last resort" are of little force when eager funds seek an oudet. Contrariwise, in a general wave of pessimism, banks find themselves with funds for which no lending oudet can be found because borrowers are unwilling to expand. The efforts of bankers to act as "optimists of last resort" are of litde force when borrowers see no future.

This view of banking as a balancing act which occasionally breaks down in cumulative expansion or contraction leads naturally to a view of business fluctuations as driven by the instability of credit. For considering the world of the 1920s, when the public sector was only a small fraction of the economy, such a view had considerable merit. In the modern economy, however, the sheer size of the public sector has tended to reduce the importance of instability emerging from the private sector. However, the public sector has often proved an independent source of instability feeding into the private sector. For example, much of the wasteful construction of the 1980s stemmed directly from ill-considered deregulation of banking and changes in tax law, shocks then magnified by the inherent instability of the private credit system. To the extent that we have failed to achieve the potential stabilizing benefit of a large government sector, the old view of inherent instability remains relevant today.

When one views the economy as a cumulative process, external events take on great importance as initiating factors in upswings and downturns. Shocks are not absorbed by an equilibrating system but magnified by its inherent instability. Indeed, much of the postwar economic record can usefully be seen as the reflection of a succession of wars and near-wars which periodically have shocked the economy: the Korean War, the Vietnam War, the nuclear arms race, various smaller military adventures in Latin America, and most recently the Gulf War. Increasingly events in economies outside the United States have also shocked the U.S. economy in one direction or another. The economic miracles of Japan, Germany, and Italy, stagnation in Latin America, the industrialization of Southeast Asia, the failure of population control in Africa, Latin America, and India, and now the transformation of Eastern Europe—such events have reshaped over and over again the composition and intensity of foreign demand for U.S. products and the composition and intensity of the supply of foreign products.

It follows from this view that it is impossible to steer the U.S. economy with any degree of precision. It seems that moderate fluctuations will take place whether we like it or not, and may be worse instead of better if we outsmart ourselves by trying too hard to stabilize them. Of course, there does remain an important role for government intervention to prevent slumps from becoming depressions and to prevent booms from becoming runaway inflations. Productive activity may on occasion drop so fast, or remain below potential for so long, as to make stimulative actions necessary. And prices on occasion may rise so fast as to call for restrictive policies of an intensity we would otherwise reject. But such crises aside, experience shows the futility of fine-tuning. The appropriate role of government is rather in designing, installing, and maintaining a set of institutions capable of supporting sustained and vigorous growth.

As against this view of fluctuation, the principal alternative treats fluctuation not as pathological breakdown but as the natural rhythm of growth in an industrial economy. Through the work of Arthur Burns and Wesley C. Mitchell, the idea of the "business cycle" and its "phases" has become deeply entrenched in American economic thought. The picture they painted of the economy as a perpetual-motion machine represented a retreat from Schumpeter's compound-cycle models to the more modest approach of tracing and interpreting peaks and downswings, troughs and upswings. The main problem with the "cycle" view is its tendency to conceive of fluctuation as self-generating and self-correcting, with each phase developing in such a way as to make its own continuation impossible. To be sure, processes that tend to reverse themselves are at work much of the time—but not all the time. There are also processes through which downswings and upswings (and periods of prosperity and stagnation) can prolong themselves. Low activity may set up such an obstacle to expansion that internal economic forces are insufficient to stimulate an upturn. Similarly, high activity may promote investment spending for new facilities, which keeps breathing new life into an expansion.

EVOLUTION FROM STABILITY TO INSTABILITY

The U.S. economy emerged from World War II with a set of institutions inherited from the rescue operations of the 1930s, institutions that subsequently provided the basis for a remarkable two decades of sustained growth. At the time, much credit was given to the ability of the government to stabilize the economy by using the tools of fiscal and monetary policy. Less careful practitioners even proclaimed that the business cycle was over. In retrospect, it seems that when we thought we were managing the economy, we were only experiencing the benefits of a robust expansion. When the sources of that expansion played out and the economy really needed managing, our tools turned out to be inadequate for the task.

One key to the stability of the early post-World War II period was the prevalence of institutional constraints on the flow of credit. Upward instability was limited by the underdeveloped character of private capital markets, a legacy of the wartime focus on channeling funds to the public sector, so that any speculative boom had to take place entirely within the intermediated credit sector. And because intermediaries were limited by regulation to channeling funds from one particular source to one particular use, banks were incapable of sustaining a speculative boom, since disintermediation inevitably cut off the supply of funds to the booming sector. Thus banks were able to concentrate on the balancing act that is their forte, without facing the deeper problems of a runaway credit boom. In this institutional setting, the traditional tools of monetary policy were powerful weapons, but they were rarely employed. After a decade of experience with such a system, it was easy to forget the Hawtreyan message about the instability of credit.

The other key to postwar success was the pent-up demand of wartime paired with capacity to meet that demand after conversion of wartime production capacity to civilian use. Downward instability was limited by the upward swing of a new long Kondratieff wave based on the enormously enhanced role of government, a shift from intranational to multinational operation of business, the conversion of wartime technological developments to civilian use, and the accumulation of government wartime debts in private-sector portfolios. Flush and liquid, businesses and households had the means to express their demands, and the economy had the means to satisfy those demands. In the ensuing expansion, demand was so steady and growth so sustained that business fluctuations were mild. Few remembered Schumpeter's teaching that fluctuations during the upswing of a Kondratieff were bound to be mild. Instead, we were lulled into the belief that something fundamental had changed in the way the economy grew.

But wishing doesn't make it so. As postwar stores of liquidity were used up, borrowing became more important and disintermediation became politically and economically more problematic. As a consequence, the 1970s saw gradual dismanding of Depression-era institutional constraints on credit flows, a process that proceeded even more rapidly in the 1980s. And when disintermediation no longer tempered the upward instability of credit, we began to see once again the kind of cumulative speculative dynamic Hawtrey had written about. At the same time, as the sources of the long Kondratieff expansion began to dry up, business fluctuation reemerged with a vengeance, and prosperity gave way to stagnation.

The return of monetary instability in the 1970s and 1980s must be attributed in part to the spate of financial innovations that arose to evade the financial rigidities put in place in the 1930s. Increasingly, borrowers found they could borrow more cheaply and reliably in the open market than from banks; e.g., by issuing commercial paper. And wealthholders found they could invest their funds more profitably in the open market than in bank liabilities; e.g., by purchasing shares in a money market mutual fund. As a consequence, over time the banking system became less important as a mechanism for channeling funds from pessimistic wealthholders to optimistic borrowers, and more important as a mechanism for enhancing the credit of loans funded elsewhere. Instead of allocating credit among potential borrowers, banks came to function de facto as underwriters of debt securities, and guarantors of repayment through off-balance-sheet commitments which continue even after the loan is "securitized" and sold.

As a consequence, the crucial regulatory role formerly played by the lending officer has been replaced by the asset-management decisions of professional money managers in pension funds, insurance companies, and mutual funds. Where once banks made loans with funds placed on deposit, now money market mutual funds issue shares against a portfolio of high-quality short-term liquid assets such as commercial paper. To the extent that the commercial paper they hold is issued as a substitute for a bank loan (or issued by a finance company in order ...

Table of contents

• Cover
• Half Title
• Title
• Copyright
• Contents
• Preface
• Introduction
• PART I: Debt, Crisis, and Recovery Revisited
• PART II: Debts and Recovery, 1929 to 1937
• About the Authors