Moral Hazard, part four

During the Great Depression there was a recurrent theme of "Where did all the money go?" It has been a constant surprise to me that scarcely anyone asks where the money which had fueled the roaring twenties came from. My answer is that the U.S. enjoyed prosperity because all parties in the European war now called World War I used deficit spending to finance the war, and the U.S. was late to come to that party. (This was before Keynesian economics. John Maynard Keynes himself hadn't figured out what was going on.)

If I had to choose one time and place where a requirement to balance budgets could have prevented not only our current economic troubles, but also a great deal of collateral damage, it would be at the outset of World War I. In my imagination I see a minister of finance saying "I'm sorry your imperial highness, legal requirements to maintain a balanced budget won't permit us to launch a general European war." Alas, I'm doing something logicians regard as worse than using collateralized debt obligations, I'm trading in counterfactuals.

You can't blame those deficits on socialists, because the governments which launched the war were emphatically not socialist, they were imperial. This was simply the old-fashioned use of political diktat to steer economies in the direction required to fund wars. The traditional idea in this case is that the victors will extract the cost from the defeated. When the war ended, Germany had scarcely been invaded, but the German economy was a shambles. The idea that anyone was going to pay for their losses through reparations was fantasy, but a popular one among victors.

A similar misconception applied to all those loans the U.S. had made to sovereign nations during the war. The prospect of such large defaults ultimately led to these loans being settled at so many cents on the dollar. Those debtors who waited the longest got the best deals.

If the money which flowed into the U.S. economy during this period had no real backing, in terms of functioning economies, how did it produce a boom? The simple answer is that people were hypnotized by meaningless numbers. They thought these numbers were backed by gold, which flooded into the U.S. while the war was in progress. They had not thought ahead to what they could exchange their money for, other than gold.

(More truthfully, the gold didn't actually move to the U.S. Unrestricted submarine warfare made that too risky. It was moved on pallets from one section of a vault to another. This makes the situation even more surreal.)

Why gold? Well anyone could see that gold was money, couldn't they? (German: das Gold, versus das Geld.) This takes us into a theory of value based on scarcity, as articulated by one economist we'll meet again, John Law. Unfortunately, scarcity is not enough. I've never heard of a currency based on ambergris, which is certainly scarce. We'll take another pass at this after we deal with some consequences of WWI.

Damage to most major economies was extreme. Many countries could barely feed their own people. A great deal of infrastructure necessary for industrial economies had been wrecked, or allowed to languish. Before this could produce new wealth, it would require major investments, which were not forthcoming. By any plausible measure, the world entered 1919 poorer than it had been in 1914, before the orgy of destruction.

With a great deal of real value still missing in action, and little understanding by governments, financiers naturally shifted to other means of increasing the money supply which were within their control. This is where we get into a very tricky question about just what is this stuff you call money.

When you put your money in a bank, the bank doesn't want to sit on this until you get around to withdrawing it, they are paying you interest. The money is loaned out as quickly as practical. This means the money listed in your bankbook is also being spent elsewhere in a presumably productive way. It is being counted twice. The money supply has increased.

Obvious scams based on this are as old as banks. This has repeatedly reached the level of entire nation's going bankrupt. (One defense against this is the "real bills" theory of value, also articulated by John Law. Alas, this is not enough, as we shall see.)

If I treat myself as an economy, with my own central bank ("My Bank"), I can write myself a loan for one million dollars, on the grounds that this will certainly enable me to achieve my destined place in the new economic order. The problem is getting anyone else to recognize my innovation as legitimate. The trick is to hide the fact that I have loaned myself the money. Obfuscation -- and a plausible cover story -- becomes essential.

Example: During the roaring twenties one such cover lay in Florida real estate. This was likely to be taken as a solid value. ("Buy land. They ain't making any more of it.") Few people actually checked if the property they bought for speculation lay above water during the wet season. (It was particularly hard to check on property at such times.) There was also an unfamiliar risk of hurricanes. During 1926 and 1928 two especially destructive storms hit Miami Beach and agricultural communities around lake Okeechobee. Some communities simply disappeared when dikes and levees collapsed. Not only did this have a direct effect on property values, it also hit the insurance industry hard. The boom started to unravel. (Others will tell different stories. This is only one thread in an extremely complex braid.)

Because leverage had been a good thing, while the market was going up, many people had been buying stock on margin. This had reached the level of people cashing their paychecks and buying touted stocks on margin at the teller windows of banks. When things started going bad, they began to get something they had not planned on -- margin calls. A deflationary cycle with positive feedback developed. As people liquidated investments to cover margin calls, prices plunged further, generating more margin calls. The whole thing had been seen before, simply not on such a huge scale.

In fact the above John Law, a Scottish-born economist, was behind a scheme which became known as "The Mississippi bubble". He didn't put his theory of "real bills" into practice in Scotland, possibly because he was wanted there for murder. His influence in France ultimately led him to become the major financial power in the nation, below the King. He could issue stock, or print money. He was considered a wunderkind because of the economic expansion he triggered, which made certain nobles extremely rich. The stock he issued was backed by land in America, in a region called Louisiana at the time. (This is more related to the later Louisiana purchase than the boundaries of the present state.) After the survivors of attempts to use this land reported on a nightmare existence, the stock, and his reputation, began a long fall from grace. Law decamped to Venice with a portable fortune in gold, one step ahead of authorities. (In the process I suppose he demonstrated yet another theory of value.)

Law's 'system' left such a bad taste in French mouths that it put a crimp in the formation of corporations and stock exchanges there for generations. (I suspect the Wikipedia entry on him in English takes a better view than the corresponding article in French. Perhaps some francophone reading this could report results of a comparison.)

The 'real bills' theory of value makes its appearance repeatedly in history. During the American Civil War, money backed by cotton was issued by the Confederacy. The catch here was that the Union blockade made it difficult to sell that cotton. A value which can't be realized is not real. Despite this backing by real goods the currency went into a familiar inflationary spiral ending in a total crash.

(Perhaps you, like others, have a relative who touches you for loans to bridge "a temporary problem of liquidity". If so, you will know those ominous words only too well.)

Meanwhile, back in the roaring twenties, we still have the question of where the money came from to fuel the U.S. economic expansion. We will start with the idea this was backed by gold.

Lets do a thought experiment about a economy solidly backed by gold. For people within the economy, like farmers growing potatoes and cooks buying them, the backing simply means that so much equivalent of gold changes hands when the farmer borrows money to plant or harvest potatoes and the cook pays the farmer to buy them. Doubling the gold backing the currency would not change the way these transactions function, unless the parties to the transaction are using currencies with a different ratio of backing.

In the 1920s virtually all food, for example, consumed in the U.S. was produced here. Very little, compared to the present, was imported. Far more food was exported. Likewise, most durable consumer goods and industrial equipment available was produced in this country. Europe was still retooling following the war, and repairing damage. So, what backed the purchase of all the goods in the 1920s?

It turns out the sovereign debt from the war was the equivalent of today's AAA rating bonds. While this remained true, the money, as in our tiny example, was being counted twice. The boom was fueled by I.O.U.s considered as sound as gold itself. People who lent money to the losers in the war lost their investments, surely the winners would not default? They didn't actually default, but they delayed payment long enough so that creditors were happy to get so many cents on the dollar.

This takes us into questions about the economics of war and sovereign debt. As it happens this subject has again become topical, (my exposition has been "overtaken by events".)


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