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Monday, January 1, 2007

Monetary-Policy Disasters of the Twentieth Century

The Federal Reserve System creates more problems than it solves.

The Federal Reserve System was created in 1913 and soon did what central banks almost always do: it started printing lots of money. During World War I the Bank of England inflated its money supply, and as a result, a significant amount of gold flowed out of Great Britain to the United States in the 1920s. Instead of controlling their monetary expansion, the British authorities put pressure on the U.S. government to expand its own money supply. The Fed happily complied and engaged in significant monetary inflation throughout most of the decade. This extra liquidity helped fuel the stock-market boom, but by 1928 it was obvious that monetary expansion had gone too far, and the Fed changed course. What ensued was a massive contraction of the money supply, followed by many years of incoherent and incompetent monetary policy that strongly contributed to the length and severity of the Great Depression.

When the Federal Reserve started restraining the money supply, stock-market growth declined and soon a pull-back developed. In the 1920s, the use of debt by both banks and individuals to invest in the stock market was common. Today, Federal Reserve margin requirements limit debt for stock for purchases to 50 percent. But during the 1920s, leverage rates of up to 90 percent debt were not uncommon. When the stock market started to contract, many individuals received margin calls. They had to deliver more money to their brokers or their shares would be sold. Since many individuals did not have the equity to cover their margin positions, their shares were sold, causing further market declines and further margin calls. The stock market crash of 1929 was the result.

In the 1920s, banks were allowed to invest their assets in the stock market, so many banks went bankrupt as well. The Glass-Steagall Act of 1933, one of the many new Depression-era banking regulations, made equity positions for banks illegal. This act split banks into two types: commercial banks and investment banks. (This law was repealed in 1999.)

The events of 1929, largely caused by government intervention in the economy, were used as an excuse for much more government intervention in the economy. Because of the extreme overprinting of money during the 1920s, the Fed had nowhere near the amount of gold necessary to cover all the claims it had printed. The American people were wise enough not to trust the banking system and attempted to get their gold out of America’s banks. The Roosevelt administration responded by closing down the banks (declaring a banking holiday) and defaulting on the gold standard. In 1933, President Roosevelt signed Executive Order 6102 making private ownership of gold for investment purposes in the United States illegal. Roosevelt also seized most of the American citizens’ gold coins, melted them down, and put them in Fort Knox.

At the Bretton Woods conference in 1944, the world was again temporarily on something resembling the gold standard. All the world’s major currencies were fixed to the dollar, and the dollar was fixed to gold. An ounce of gold was supposed to be worth $35 forever after. The U.S. central bank then proceeded again to print too much money. Throughout the 1960s, various European central banks, particularly the French, redeemed their dollars for gold. The United States had too little gold to meet the demand, so in August 1971, President Richard Nixon suspended convertibility of the dollar and defaulted on the Bretton Woods agreement. The gold standard was abandoned, and currencies soon floated against each other.

The leaders of the Federal Reserve System did not learn from this experience. They still kept overprinting money, and the Consumer Price Index (CPI) continued to climb. (An increase in the CPI is often, misleadingly, called the inflation rate. Other things equal, inflating the money supply sets off a general rise in prices.) In 1960, the CPI increased less than 1 percent, but by 1970, it was up to over 5 percent. Predictably, political leaders addressed the effects, not cause. In 1971, Nixon tried to outlaw the symptoms of inflation by imposing wage and price controls. In 1974, his successor, Gerald Ford, launched the WIN (Whip Inflation Now) campaign, but the “printing presses” kept running and inflation kept increasing. In 1980, under President Jimmy Carter, the “inflation rate” peaked at over 12 percent. While this was high by U.S. standards, other countries fared far worse. In 1985, the annual increase in Bolivia reached 11,749 percent, in Argentina 672 percent, and in Brazil 227 percent.

As inflation raged, purchasing power evaporated. Nominal wage increases and profits were illusory, wreaking havoc with people’s ability to do economic calculations and pushing them into higher income-tax brackets. When market participants came to expect inflation, the economy slowed down and unemployment increased, even as prices continued rising. This was the supposedly impossible “stagflation” of the late 1970s.

Excessive monetary expansion resulted in another financial disaster in the latter part of the 20th century—the savings-and-loan fiasco. This was the largest banking failure in U.S. history. Over 1,000 S&Ls failed, resulting in the bankruptcy of the Federal Saving and Loan Insurance Corporation (FSLIC) and a loss of over $150 billion, of which over $120 billion was covered by the U.S. taxpayers. Many culprits have been blamed for this banking disaster, from junk bonds to greedy and corrupt banking officials, but the primary reason for the widespread failures in the industry was irresponsible monetary policy at the Fed.

By law, S&Ls could only invest in 30-year fixed-rate home mortgages. The main source of their funds were savings accounts from which depositors could withdraw their money anytime. This led to what is known as a duration mismatch. During the low-inflation periods of the 1950s and 1960s, the S&Ls made many 30-year fixed-rate loans that were still outstanding in the 1970s and 1980s. But when prices were rising 12 percent a year, while an S&L’s mortgages yielded only 6 percent and its savings accounts paid only 5.5 percent, something had to give.

The reason S&L accounts paid only 5.5 percent was the government’s Regulation Q, which imposed interest ceilings on savers. Meanwhile, U.S. Treasury bills were yielding over 8 percent in 1970 and over 15 percent around 1980. But to buy a T-bill an investor needed $10,000. Thus, rich people could shift their money from savings accounts to T-bills, but those without $10,000 were stuck. Fortunately, the money-market mutual fund emerged in 1971. This type of account allowed people to pool their money with other small investors and together purchase T-bills and commercial paper. Now small investors could also purchase high-yield short-term investments.

With small depositors moving their money from savings accounts to money-market funds, a process called disintermediation, the S&Ls were in trouble. They responded by offering toasters and other giveaways to attract customers, but that did not work, and massive bankruptcies ensued. In 1982, the Garn-St. Germain Act legalized money-market mutual funds without an interest-rate ceiling.

Volcker to the Fed

In 1979, Jimmy Carter appointed Paul Volcker to head the Federal Reserve. Volcker did what he said he was going to do. He drastically increased short-term interest rates to control inflation. In 1980, short-term interest rates were much higher than long-term interest rates. Since S&Ls made their money by borrowing short and lending long, this contributed further to their destruction. By 1982, the “inflation rate” had dropped to around 4.25 percent, but many S&Ls were bankrupt, with total losses of over $100 billion.

In a desperate effort to fix the problem federal regulators allowed the S&Ls to engage in questionable accounting practices and riskier (and hopefully) more profitable investments. It did not work, and by the end of the 1980s, S&L losses had risen to over $150 billion. Since the liabilities (depositors’ money) were federally insured, the taxpayers had to pick up much of the tab. Finally, in the late 1980s and early 1990s, the insolvent S&Ls were shut down. With the price index back to normal, stability gradually returned to the financial markets.

In 1982, one of the greatest bull markets in U.S. history began and continued until 2000. While inflation measured by the consumer price index has been relatively mild in the United States since the early 1980s, the money supply has continued to expand at a rapid rate. It is likely that this expansion contributed to the stock-market bubble of the late 1990s and the housing boom of the early 2000s.

Not everyone benefited from the re-stabilization of the financial markets. In societies where the currency is unstable, people naturally turn to other stores of wealth. Gold and real estate are common investments, and the United States during the 1970s was no exception. While the stock market floundered during the 1970s, the real-estate market boomed. The increase in real-estate values included not only houses but also farmland. When the price of farmland increased, farmers in the Midwest were able to take out larger bank loans and drastically expand their operations. But when real-estate prices declined, the leverage ratios on farms drastically increased. During the 1980s, many farm bankruptcies followed.

The Great Depression of the 1930s, the S&L fiasco of the 1980s and 1990s, and the farming crisis of the 1980s are all testaments to the extremely destructive effects that an irresponsible monetary policy can have on a society. Policymakers allegedly created the Fed to prevent these sorts of problems. Official goals of the system include maximizing employment, stabilizing prices, and maintaining moderate long-term interest rates. (See here for more information.) It is interesting to note, however, that the only extended periods when the U.S. economy did not experience significant inflation occurred when the United States had no central banking system.

  • Kirby R. Cundiff, Ph.D., CFA, CFP® is Chair of Accounting and Financial Management at the Graduate School of the University of Maryland University College. He was formally Chair of Business Administration of the Rochester Institute of Technology Dubai, UAE campus.