Monday, September 13, 2010

The Deal of a Lifetime: Part 1

Written by the Financial Loon

The policies enacted and institutions established during the New Deal era would put America on a new course, one nearly impossible to turn away from. Once established, these systems would end up with so much popular support and be so ingrained into our society that changing them is unthinkable. Key ideas I will touch on are our practices of money creation, social welfare, and drive toward homeownership.

A Pretext: The Roaring Twenties
The end of World War I gave rise to unprecedented development in the United States. Undamaged by the catastrophic destruction seen across Europe industry in America quickly reworked itself to provide ever increasing amounts and varieties of consumer goods. Workers flooded into American cities causing huge growth across burgeoning utility sectors. A vast number of residential structures, power plants, and highways were built to accommodate this urbanization. As you can imagine loans and bonds for development were issued en masse during the 1920s.
Traditionally such actions had not been an issue, but in a time when the dollar was ultimately backed by gold and silver the sheer scale of growth finally outpaced the money supply. While physical gold and silver only accounted for 5 billion of the 50 billion dollars in the average money supply for the period they established a ceiling on the total amount of money that could be put into the system. A policy of fractional reserves allowed banks to issue loans for many times the amount of actual gold and silver holdings they possessed thus creating the additional 45 billion available dollars. The fantastical growth of the 1920s established a situation where a fairly consistent amount of money chased an ever increasing amount of goods and services. The dollar price for all things was pressured downward, much as prices would be pushed upward in a reversed situation. These are known as deflation and inflation.
At face value deflation would not seem to be a problem, your money buys more today than it did yesterday. Thought of in terms of preexisting debt it is very bad, your rent effectively becomes more expensive, as its price is fixed in contract but the value of your money is going up. Your wages won’t be going up because the price of labor with fall along with everything else. Another effect of deflation is that it impairs sellers of goods. Take farmers for example, their crops fetch a lower price at market this year than they did last year. When you are a farmer paying rent on your farm… you get the picture.
The same is true for the businessman in the city who runs a textile factory. The garments he sells make him less money while the loans on his factory and machinery effectively cost him more and more. A key problem with deflation is that wages fall, making the repayment of debt even more difficult. The businessman is forced to cut wages or risk going out of business. Further down the road these effects cripple the local banker who suddenly has his customers defaulting on their loans. Even the large banks were in trouble due to the rampant practice of on margin stock sales, loaning people money so they can buy stocks, this greatly expanded the banks’ exposure to the risk of the businessman’s factory closing. Before long you have all sectors of the economy in chaos.
A Story of Two Metals
Five days into his presidency Roosevelt pushed forward the Emergency Banking Act. The act ordered the return of much of the gold withdrawn during the recent panic. Lack of gold reserves had a large negative multiplier effect on the amount of money banks were able put into the economy. In all a third of a billion dollars in gold was brought in, at $20.67 per ounce, from private citizens. However, additional gold reserves alone were not enough to provide enough dollars for the economy to function. Less than a year later the Gold Reserve Act finalized a swift revaluation of the dollar to $35 per troy ounce.
This reduced the value of all dollars, and also allowed for more dollars to be put into circulation which compounded the reduction in their value. During a time of great deflation controlled inflation was actually the desired means to stabilize prices. Nevertheless, gold manipulation alone was not sufficient to balance the system. The Silver Purchase Act of 1934, passed a few months later, worked to substitute gold reserves with massive purchases of silver. Similar to the previous acts it built up the physical holdings of the Treasury and then revalued the asset.
Recall the 5 billion and 50 billion figures from earlier. They were the average just before this chart begins and are represented in blue and green. As people removed money from the system in fear of losing it they reduced the amount banks were able to lend, due to their reserve requirements. The monetary base represents tangible currency; gold, silver, and paper money representing such. This money can be removed from bank vaults but is not destroyed.
Money stock includes the additional money created by banks, money that circulates as checks. This second class of money is created when banks make out loans but are only required to keep a certain fraction of base money in reserve to cover the loans. The practice of fractional reserve banking allows the flow of money to be easily expanded. This works fine so long as depositors don't take out their base money all at once. A bank run robs the bank of its ability to create money stock. In this case the money is actually destroyed.
By doubling the amount of base money in five years, Roosevelt established a ceiling of money stock high enough to accommodate the vast growth seen during the previous decade. Wisely he did not immediately increase the money supply to the top amount now allowed. Doing so would have increased the flow of money to a point of uncontrolled inflation. Instead sums of money were released steadily to reinflate prices to earlier levels. The act of balancing prices between extremes of inflation and deflation by means of controlling the money supply is one that continues to this day.
Knowing that another run on the banks could again destabilize the economy Roosevelt had already included the creation of the Federal Deposit Insurance Corporation in the Banking Act of 1933, a follow up to the Emergency Banking Act. The FDIC guarantees that money stock lost in a banking failure will be reimbursed with base money by the US government. This promise alone was enough to persuade citizens to flood back to freshly reopened banks and deposit much of the money they had hidden away.

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