Reuther, head of the US car
workers’ union, told of a visit to a new automatically operated Ford plant.
Pointing to all the robots, his host asked: “How are you going to collect
union dues from those guys?” Mr Reuther replied: “And how are you going to get
them to buy Fords?”
Then and Now: 1929-2008
The Dynamic Role of Central Banks in the
Boston Symposium on Economics
Northeastern University Economics Club
George H. Blackford (02/10/2014)
The Dynamic Role of Central Banks in the Economy, I am going to begin with
a reexamination of some economic history—history that I believe helps to
explain the role played by the Federal Reserve in the current financial
crisis, as well as what I believe to be the fundamental economic problem we
the Federal Reserve
The Federal Reserve was founded in 1913 in an attempt to
deal with what was perceived, at the time, to be the central problem of the
National Banking System. Namely, the inability of this system to deal with
increases in the demand for currency without placing a strain on banks and
their ability to make loans.
This problem was dealt with by creating the Federal
Reserve as a central bank with the power to print its own currency. It was
believed at the time that, given this power, the Federal Reserve would be able
to at least manage, if not eliminate, the financial crises that had plagued
the National Banking System by lending currency to sound banks during times of
financial stress while allowing unsound banks to go out of business in an
While the Federal Reserve was able to solve the demand
for currency problem, it was not able to solve the financial crisis problem.
The inadequacy of the Federal Reserve in this regard became painfully obvious
as the economy worked its way through the Roaring Twenties and into the Great
Depression of the 1930s.
The 1920s began with a mild recession in
followed by a
speculative bubble in the real estate market.
The real estate bubble burst in 1926 and was superseded by a speculative
bubble in the stock market. There was a mild economic downturn in
1927, a brief
recovery that same year, and another mild downturn in the summer of
1929. Then, the
stock market bubble came to a dramatic climax in the fall of that year. (Galbraith
Crash of 1929
began on October 24—a day that became known as
when the market dropped dramatically in the morning and recovered somewhat in
the afternoon. While prices rallied on Friday, there were two more black days
to come. When trading resumed after the weekend, the Dow fell
Black Monday and
then an additional
There were rallies that followed, but, overall, the stock market lost
80% of its value
from its high in 1929 to its low in 1932 and the Dow fell by almost
The Crash of 1929, and the events that followed, shook
the confidence of the public in the banking system. Since there was no such
thing as deposit insurance until 1933, the result was a run on the banking
system that began in the fall of 1930. This led to utter
panic as financial institutions tried to cut
their losses by recalling existing loans and refusing to make new loans, not
just loans collateralized by real estate and
stocks, but all loans. This forced
debtors whose loans were called or who could not refinance their loans to sell
the collateral underlying their debts—as well as other assets—in order to meet
their financial obligations. (Fisher)
As this drama unfolded, it became impossible for the
Federal Reserve to resolve the situation by simply providing currency to sound
banks while allowing unsound banks to go out of business. The problem was not
that sound banks needed cash to meet their depositor’s demands for currency.
The problem was that the forced sale of assets throughout the system caused
asset prices to fall, which, in turn, caused the value of the collateral
underlying bank loans to fall below the value of the loans that had been
made. This drove otherwise sound banks into insolvency, and banks became
unsound faster than they could be saved.
By the time the banking crisis reached its climax in
1933 we were in the depth of the Great Depression. Some
4,000 banks and
and loans went under in that year alone, and some
10,000 banks had
gone out of business since 1929 along with
businesses. Over 11 million people lost their jobs as unemployment rose to
25% of the labor force. (ERP)
The total value of goods and services produced in the United States fell by
46%, the level
of production by over
30%. And just
as happened in 2008, the financial crisis in the United States spread
throughout the rest of the world, and the entire world faced an economic
catastrophe of epic proportions. (Kindleberger)
The depression lasted more than ten years.
There were still
8 million people unemployed in 1940, and
the unemployment rate did not fall below
until 1941. It wasn't until 1943—when the economy was fully mobilized for
World War II—that the unemployment rate finally fell below its 1929 level, and by
then we had increased the size of the military by over
8.5 million soldiers.
In other words, we did not solve the unemployment
problem created by the Great Depression until the government had completely
taken over the economic system and had increased the military by more than the
number of people who were unemployed in 1940.
What’s more, the economic system that emerged from our
experiences during Great Depression and the war that followed was not the same
economic system that had led us into these two great tragedies.
It was different in at least two fundamental ways.
Distribution of Income
The first was in the distribution of income. The
concentration of income at the top of the income distribution increased during
the 1920s as the share of the total received by the top
1% went from
15% in 1920 to
19.6% by 1928. It then
dropped significantly through 1931 as the crisis unfolded, but it fell below
15% in only one year during the 1930s and averaged
16% for the decade.
As the government took over the system during the war,
the income share at the top fell to
11% by 1945 where it more or less remained until
1950, then dropped to
9% by the end of the Korean War. It continued to
fall throughout the 1950s and 1960s until it reached a low of
7.7% in 1973.
The second way in which the post-war economic system was
fundamentally different from that of 1929 has to do with the way in which the
government viewed financial regulation.
The vast majority of our political leaders, and
most renowned economists,
entered the 1930s with an abiding faith in the nineteenth-century ideology of
free-market capitalism. They were convinced that markets were self
correcting; attempts at government intervention would do more harm than good,
and that if the economy was just left to its own devices competition in free
markets would allow wages and prices to adjust to bring the economic system
back to full employment. Many, if not most, even believed the economic system
would be made better by the experience of a depression in that depressions
weeded out economically inefficient firms and, thereby, made the economy more
The experience of the 1930s shook these beliefs. With
total output falling by
30%, unemployment at
25%, tens of thousands of business going bankrupt,
and human misery increasing at an increasing rate, it was impossible for
economists to explain just how the economic system was going to be made better
by all of this or why the government should not be allowed to intervene to try
do something about it.
There had to be something wrong with an ideological
theory that proclaimed it was good for society to be going through what it was
going through at the time. What’s more, the only explanation the theory could
offer for the dismal employment statistics was that wages were not falling
fast enough to bring the system back to full employment. But by 1933, wages
had already fallen by
22% in manufacturing,
26% in mining, and
53% in agriculture.
There was obviously something wrong with the theory.
It was clear to most people at the time, that the cause
of the crisis was rampant speculation in the stock market financed by
expanding debt. In fact, the debt created by the financial system during the
1920s had grown to unreasonable levels in all areas, not just in the stock
market. This debt was unsustainable, and the stock market crash was just the
trigger that set in motion a set of forces that, in the face of this debt,
brought down the entire economic system.
It was the fear that people and financial institutions
would not be able to meet their financial obligations—that they would default
on their debts—that led to the panic that brought down the financial system
and, ultimately, the rest of the economy following the Crash of 1929. (Fisher)
In 1932 the Senate Committee on Banking and Currency
authorized what came to be known as the
Pecora Commission to investigate the causes of the
developing depression. This commission exposed massive levels of fraud,
corruption, conflicts of interest, and incompetence on Wall Street which led
to a public outcry for government regulation of the financial sector. In
response, our political leaders of the 1930s through the 1960s abandoned the
failed nineteenth century ideology of free-market
capitalism in favor of a pragmatic regime of regulated-market capitalism. (Moyers
This led to the creation of an elaborate
system of regulatory and supervisory institutions
designed to keep our financial system in check. (Chapter
Importance of Income and Regulation
It seems to me, that these two fundamental changes in
our economic system—the fall in the concentration of income and the rejection
of an ideology view of the world that prevented the regulation of our
financial system—played a crucial role in creating the economic prosperity
that followed World War II.
The reason is, we live in an age of mass-production
technology, and selling the mass quantities of goods and services that can be
produced with this technology requires mass markets—that is, markets with
large numbers of people with purchasing power. The requisite purchasing power
needed by these large numbers of people can be obtained either from their
income or through a transfer of purchasing power from those who have it (and
don’t want to purchase newly produced goods and services) to those who don’t
have it (and do want to purchase newly produced goods and services)—a transfer
that generally takes the form of an increase in debt.
The fall in the concentration of income during and
following the war had the effect of increasing the purchasing power out of
income for 99% of the population, and, thereby, avoided the need to rely on an
increase in debt to provide this increased purchasing power to that 99% of the
population. This, in turn, bolstered the domestic mass markets that fueled
our economy following the war, and, in conjunction with the regulatory system
that had been put in place in the 1930s, made sustainable economic growth
possible without the kinds of speculative bubbles that led to the increase
in debt and concentration of income during the 1920s that eventually
brought down the economic system in the 1930s. (Chapter 3)
The result was thirty years of economic prosperity in
which the standard of living increased dramatically for almost everyone in
Unfortunately, as new generations replaced old, and
memories of the 1920s and Great Depression faded, an antigovernment movement
began to take hold in the 1970s, and the
failed nineteenth century
ideology of free-market capitalism—with its
mantra of lower taxes, less government, and deregulation—became fashionable
again among our economic and political leaders. (Krugman
As a result, the regulatory and supervisory systems that
served us so well since the 1930s were systematically dismantled, a process
that began, more or less, in the 1970s.
The pernicious effects of this change in attitude toward
regulation became manifest early in the1980s after legislation was passed to
relax the restrictions on banks and, in particular, on savings and loans and
savings banks. (DIDMC,
The result was an explosion of credit in a number of
regional commercial real estate markets. As the speculative bubbles in these
markets burst in the mid to late 1980s we were faced with the first major
financial crisis in the United States since 1929. (FDIC)
In the end, some 1,300 savings institutions failed, along with 1,600
commercial banks, and some 300 fraudulently run savings and loans that were
nothing more than
Ponzi schemes failed at the peak of this disaster.
It costs the American taxpayer
$130 billion to bail out the depositors in these
failed institutions, and the resulting financial crisis was a precursor to the
1990-1991 recession. (Black
While there were attempts by Congress to reregulate the
financial system in the late 1980s and early 1990s, the cat was out of the
bag. The fortunes made by those who had looted the savings and loans during
the 1980s clearly demonstrated how a lack of oversight on the part of the
government benefited those who were willing to bend or ignore the law. Even
though over a thousand individuals associated with the savings and loan
debacle were convicted of felonies, most walked away with their fortunes
Stewart) This was the lesson learned by those at
the top of the economic food chain from the Savings and Loan disaster, and
this same lesson was drawn from the experiences in other industries as well.
Throughout the 1980s, fortunes were made through
junk bond financing of
hostile takeovers and
leveraged buyouts that led to the dissolution of
American companies, repression of wages, the looting of corporate pension
funds and other assets, and the outsourcing of American jobs overseas and to
Usury laws were repealed, and credit card companies were
allowed to charge exorbitant interest rates and fees as they devised elaborate
schemes to lure financially unsophisticated customers deeper and deeper into
With so much money involved, the lack of government
regulation allowed the entire fiduciary structure of our economic and
political systems to become corrupted.
Management salaries and bonuses soared to astronomical
levels as the corporate governance broke down, and boards of directors became
vassals of their CEOs.
The major accounting firms found they could make more
money advising corporations on how to make paper profits to justify increases
in management salaries and bonuses than they could by providing independent
audits of companies' books for stockholders.
Brokerage firms found they could make more money hyping
worthless mutual funds and internet, energy, and telecom stocks than they
could by providing sound investment advice to their clients.
Investment banks found it more profitable to dissolve
their partnerships, become corporations, and speculate for their own account
with investors' money than to provide underwriting and advisory services to
their clients. (Bogle
The results were huge conflicts of interest—conflicts of
interest that contributed directly to the
Drexel Burnham Lambert,
Ivan Boesky, and other
junk bond, and
Savings and Loan frauds that were endemic in the
bubbles of the 1980s, the bursting of which were precursor to the
They also contributed directly to the
Global Crossing, and
WorldCom frauds that were part of the
telecom bubbles of the 1990s, the bursting of which
led to the
2001 recession. (Chapter
Debt in the Era of Deregulation
The ultimate effect of all of this, just as in the
1920s, was to increase the concentration of income and debt. By 1990 the
income share of the top 1% had reached
13% of total income, a 5 percentage point (or 60%)
increase over the
8% it had been in
1980. At the same time the debt to GDP ratio went from and
240% of GDP.
By the end of the telecom and dot com bubbles in 2000,
the income share at the top had reached
16.5%. At this point we were back to the level of
concentration at which our economic system stagnated throughout the 1930s when
there were no speculative bubbles to artificially stimulate the economy.
Meanwhile, the total amount of debt in the economy had increased to
273% of GDP.
Then came the housing bubble of the 2000s. By the time
this bubble had reached its climax in 2007 the concentration of income of the
top had increased to
of total income—just 1.3 percentage points below where it had been in 1928, a
year before the Great Crash. At the same time, debt increased continuously
relative to income, reaching to
380% of GDP by 2007, a 107 percentage point increase
in just seven years.
By 2007 the GDP stood at
$14 trillion and the total debt that had to be
serviced out of that
$14 trillion worth of gross income stood at
This debt to GDP ratio was far beyond anything we had
seen in the 1920s which reached its peak at somewhere around
200% of GDP in 1928. And to make matters worse, due
to the systematic dismantling of our regulatory system, the bulk of this debt
had been created in the absence of government regulation in a situation in
which ideological blindness led officials to believe that it was unnecessary
to enforce laws against fraud—that, somehow, self-regulating markets would
take care of that little problem without government intervention. (Krugman
Smith) As a result, fraud grew to unfathomable
levels in the subprime and alt-a mortgage markets as the housing bubble
spiraled out of control.
It was the fear of default on this fraudulently created
debt that ultimately led to the financial crisis in 2007, the crash in 2008,
and the world-wide economic depression we are in the midst of today. (Senate
Reserve in the Current Crisis
“What does all of this have to do with The Dynamic
Role of Central Banks in the Economy?” I hear you cry. As I indicated in
the beginning, I believe this history helps to explain role played by the
Federal Reserve in the financial crisis as well as what I believe to be the
fundamental economic problem we face today.
I have nothing but praise for the heroic actions of the
Federal Reserve in 2008 and 2009 in expanding its balance sheet as it propped
up foreign as well as domestic institutions and kept both the domestic and the
international financial systems from imploding. At the same time, I see the
need for these actions as being an indirect result of a failure in domestic
policy on the part of the Federal Reserve leading up to the crisis.
The Federal Reserve had the absolute authority, indeed,
a duty to regulate the mortgage market under
Home Ownership and Equity Protection Act of 1994. (Natter)
Specifically, it had the power to crack down on the fraud that was taking
place in this market and to set minimum down payments and other underwriting
standards for mortgages, but the ideological faith in free markets to regulate
themselves on the part of the officials at the Federal Reserve, in the Clinton
and Bush administrations, and in the Congress during the 1990s and 2000s kept
the Fed from doing so. (Krugman
Smith Chapter 9) If it had done so there would have been no
housing bubble, the financial crisis would have been avoided, and there would
have been no need for the Federal Reserve to prop up the world’s financial
system in 2008.
It’s worth noting, however, that even if the Fed had
regulated the mortgage market and prevented the housing bubble, it would not
have solved our economic problem. The fundamental problem, as I see it, was
the adoption of an ideological view of the world that led to the deregulation
of our financial system and an increase in the concentration of income.
The result was a distribution of income that—given the
state of technology—did not provide the purchasing power to the large numbers
of people needed to sustain our domestic mass markets at the levels required
to achieve full employment in the absence of speculative bubbles and
unsustainable increases in debt.
Even if the Fed had prevented the speculative bubble in
the housing market, and the crisis had been avoided, we would not have
achieved economic prosperity. Given the concentration of income that existed
at the time, and that still exists today, the result would have been
widespread unemployment if the housing bubble had not been there to stimulate
the economy, and there is virtually nothing the Fed could have done to have
avoided this result if the Fed had prevented the housing bubble. (Chapter
In conclusion I would note, it seems to me that if our
economic and political leaders fail to come to grips with the concentration of
income problem we face today, we are destine to continue to experience the
kinds of boom and bust cycles we began in the 1980s where we can only achieve
full employment in the midst of a speculative bubble.
It also seems to me that if we continue along the path
set for us by free-market ideologues with their mindless mantra of lower
taxes, less government, and deregulation, we will eventually end up right back
where we started in the 1930s with the same kind of economic stagnation we
experienced back then when we ran out of speculative bubbles to stimulate the
And finally, if the political and economic leaders
throughout the world continue to follow this mindless ideological mantra and
refuse to come to grips with the root cause of the worldwide economic
catastrophe we face today—namely, the concentration of income at the top of
the income distribution—it seems to me that civil unrest is likely to continue
to increase throughout the world to the effect that we could eventually end up
right back where we ended up in the 1940s. (Ideology
Possible Government Actions to Reduce the Concentration of Income
suggested policies to reduce the concentration of income:
Make banking boring again by providing strict reregulation of the
financial system to bring the markets for such things as MMMF, repurchase
agreements, and financial derivatives under strict regulation and government
Strictly enforce laws against fraud in the financial markets.
Breakup the too-big-to-fail financial institutions.
Bring our international current account balance under control.
Eliminate corporate tax loopholes and increase the income tax by adding
additional brackets at the top.
Take the cap off payroll taxes and include unearned income in the base.
Eliminate the special treatment of dividends in the tax code, and if
not eliminate the special treatment of capital gains, at least extend the
eligibility period for most long-term capital gains to something like five
Shift the resources we now put into the war against drugs into a war
against tax havens.
Use the increase tax revenues to provide universal early-childhood
education, and to subsidize higher education to the point that no qualified
student has to go into debt in order to get an education.
Make the WIC program universal for all mothers, infants, and children.
Provide a universal healthcare system that actually works.
Increase the minimum wage.
Start enforcing the laws against unfair labor practices again.
Repeal the so called “right-to-work”
provisions of the
Where Did All the Money Go?