All Commentary
Tuesday, December 1, 1992

Money of the Mind: Borrowing and Lending in America from the Civil War to Michael Milken

Money of the Mind provides an engaging look at how government monetary policies have infiltrated and corrupted the market process.

Of all the distortions government creates when it intervenes in the free market process, few, if any, are more deleterious to the economy than when it socializes credit risk. That hasn’t stopped the federal government from continuing such policies, though, as documented in James Grant’s recent book, Money of the Mind: Borrowing and Lending in America from the Civil War to Michael Milken.

Over a period of decades, the federal government has taken it upon itself to “regulate” credit markets, ostensibly to improve safety, stability, and fairness. The results have been less than impressive, however.

For example, a decade ago when the Texas real estate market was crumbling, the regional banks began feeling the fallout, Grant writes. Eventually, every key Texas bank went bankrupt during this time or was merged or required assistance from the federal government. Ironically, big Dallas banks managed to survive the Great Depression 50 years earlier with relatively little, if any, federal help.

The huge expenditures and market interventions by Washington in the more recent Texas setback had little remedial effects. In fact, such interventions are said to have exacerbated the problems because they redistributed corrective pain and thereby mitigated the healing effects of the market. “It was the received wisdom of the 1970s and early 1980s,” Grant writes, “that modern banks do not fail (thanks to federal deposit insurance) and that inflation is a permanent American condition (as a result of the Employment Act of 1946). However, the impossible proceeded to happen.”

Despite policy failures over the decades, Washington has been slowly adding layers of bureaucracy to do more of the same. Statist manipulation of credit markets has since become overt, counterproductive, and sometimes dangerous, as Grant points out regarding interventions into the banking market throughout the nation in recent decades: “The doctrine that some banks were too big to fail subverted the most basic banking franchise of all, safety; promising to protect its depositors’ money at all hazards, a small, safe bank could make no competitive headway against a large, risky bank. The Treasury Department was the ultimate big-bank stockholder.”

Grant might have added that Congress’ record in recent years on distorting banking policies is equally troubling. Consider that institution’s decision to raise the savings and loan deposit-insurance ceiling to $100,000 from $40,000 as the 1980s opened. This action attracted more money from depositors, who were comforted—some say lured—by the artificially higher levels of government guarantees. Yet that money—indirectly solicited by government guarantees—was funneled into speculative, though ill-fated real estate ventures.

A good deal of the country’s monetary and credit ills can be traced back to the creation of the Federal Reserve System just before World War I, Grant suggests. Few can argue with this notion, as this system has contributed greatly to the politicization of monetary policy, partly by removing formal institutional constraints on monetary excesses, as in the jettisoning of the gold reserve ratio.

Over the years, Fed power became increasingly centralized—a predictable development, given the nature of the beast—giving it more authority to act unilaterally and, consequently, beyond market rationality.

The Banking Act of 1935, for example, removed individual banks’ influence in open market monetary operations, ceding that ability to the Fed. Subsequently, all key monetary decisions were to come within its domain. Unfortunately, the situation has degenerated so that monetary policy choices are often derived from a political calculus. Such power shifts opened the door for Congress to sanction irresponsible fiscal policies, as in 1946 when it promoted monetary excesses by directing the Fed to promote high employment under the Full Employment Act.

By the early 1970s, the arrival of the Penn Central affair should not have come as a surprise to anyone monitoring the trends of previous decades. Grant recounts that the tribulations of this company became the most prominent example of market manipulations, partly induced, if not sanctioned, by government policies. In fact, some of the nation’s most conservative bankers, and ardent critics of state intervention as well, had experienced a philosophical change of mind as they succumbed to modern monetary mismanagement as promoted by Washington. As a result, the previously independent-minded Walter Wriston, chairman of the First National City Bank, petitioned the Federal Reserve Bank of New York in the early ‘70s for a $200 million loan guarantee as assistance in dealing with the increasingly risk-laden Penn Central, to which City Bank and other institutions had made loans.

Regardless of government intervention, however, Penn was headed for failure. And rightly so, as the company had made egregious errors in business judgment. Yet even after Penn had fallen, it was clear that the Fed system wasn’t about to mend its ways nor acknowledge market logic. Indeed, the Federal Reserve Bank of New York assessed Penn’s failure as unrelated to rational market pressures, but instead the result of technical difficulties. In essence, the bank refused to face reality, explaining that Penn crashed and burned because holders of the firm’s commercial paper “became apprehensive about the low level of corporate liquidity as well as about the ability of borrowers to refinance existing debt, given the fight position of the banking system. The difficulties encountered by a number of brokerage firms, including some of the oldest and largest houses, and the fact that stock prices continued to fluctuate erratically added to the widespread uneasiness. Moreover, the Penn Central default came at a time when the amount of maturing paper was seasonally high because of the midyear statement date.”

Overall, Money of the Mind provides an engaging look at how government monetary policies have infiltrated and corrupted the market process. To be sure, decisions made in the private sector must share in the blame for excesses, and yes, sometimes scandals. Such is the reflection of human nature rather than market failings, though.

Beyond that, such private market stumbles typically are corrected by assessing penalties to the offending parties. In contrast, government-induced improprieties in monetary affairs are rarely corrected. Instead, such statist errors are allowed to multiply, primarily because responsibility is diluted and pawned off onto millions of unwilling taxpayers who have no culpability, and no avenue for redress of grievances against the autonomous Fed.

James Picerno is associate editor of Stanger’s Investment Advisor, based in Shrewsbury, New Jersey. He is also a contributor to Barron’s, Financial Freedom Report, and Business Facilities.