War and the Austrian Business Cycle

David Stockman explains the oft-observed connection between economic contraction and military conflict. Astute observers will note that the cycle he describes correlates much better with my “Limits of Demand” modification of the core mechanism of the Austrian Business Cycle:

During World War I the US public debt rose from $1.5 billion to $27 billion—an eruption that would have been virtually impossible without wartime amendments which allowed the Fed to own or finance U.S. Treasury debt.  These “emergency” amendments—it’s always an emergency in wartime—enabled a fiscal scheme that was ingenious, but turned the Fed’s modus operandi upside down and paved the way for today’s monetary central planning.

As is well known, the Wilson war crusaders conducted massive nationwide campaigns to sell Liberty Bonds to the patriotic masses. What is far less understood is that Uncle Sam’s bond drives were the original case of no savings? No credit? No problem!

What happened was that every national bank in America conducted a land office business advancing loans for virtually 100 percent of the war bond purchase price—with such loans collateralized by Uncle Sam’s guarantee. Accordingly, any patriotic American with enough pulse to sign the loan papers could buy some Liberty Bonds.

And where did the commercial banks obtain the billions they loaned out to patriotic citizens to buy Liberty Bonds?  Why the Federal Reserve banks opened their discount loan windows to the now eligible collateral of war bonds.

Additionally, Washington pegged the rates on these loans below the rates on its treasury bonds, thereby providing a no-brainer arbitrage profit to bankers.

Through this backdoor maneuver, the war debt was thus massively monetized.  Washington learned that it could unplug the free market interest rate in favor of state administered prices for money, and that credit could be massively expanded without the inconvenience of higher savings out of deferred consumption.  Effectively, Washington financed Woodrow Wilson’s crusade with its newly discovered printing press—-turning the innocent “banker’s bank” legislated in 1913 into a dangerously potent new arm of the state.

It was this wartime transformation of the Fed into an activist central bank that postponed the normal post-war liquidation—-moving the world’s scheduled depression down the road to the 1930s. The Fed’s role in this startling feat is in plain sight in the history books, but its significance has been obfuscated by Keynesian and monetarist doctrinal blinders—that is, the presumption that the state must continuously manage the business cycle and macro-economy.

Having learned during the war that it could arbitrarily peg the price of money, the Fed next discovered it could manage the growth of bank reserves and thereby the expansion of credit and the activity rate of the wider macro-economy. This was accomplished through the conduct of “open market operations” under its new authority to buy and sell government bonds and bills—something which sounds innocuous by today’s lights but was actually the fatal inflection point. It transferred the process of credit creation from the free market to an agency of the state.

As it happened, the patriotic war bond buyers across the land did steadily pay-down their Liberty loans, and, in turn, the banking system liquidated its discount window borrowings—-with a $2.7 billion balance in 1920 plunging 80 percent by 1927. In classic fashion, this should have caused the banking system to shrink drastically as war debts were liquidated and war-time inflation and malinvestments were wrung out of the economy.

But big-time mission creep had already set in.  The legendary Benjamin Strong had now taken control of the system and on repeated occasions orchestrated giant open market bond buying campaigns to offset the natural liquidation of war time credit.

Accordingly, treasury bonds and bills owned by the Fed approximately doubled during the same 7-year period. Strong justified his Bernanke-like bond buying campaigns of 1924 and 1927 as helpful actions to off-set “deflation” in the domestic economy and to facilitate the return of England and Europe to convertibility under the gold standard.

But in truth the actions of Bubbles Ben 1.0 were every bit as destructive as those of Bubbles Ben 2.0.

In the first place, deflation was a good thing that was supposed to happen after a great war. Invariably, the rampant expansion of war time debt and paper money caused massive speculations and malinvestments that needed to be liquidated.

Likewise, the barrier to normalization globally was that England was unwilling to fully liquidate its vast wartime inflation of wage, prices and debts. Instead,  it had come-up with a painless way to achieve “resumption” at the age-old parity of $4.86 per pound; namely, the so-called gold exchange standard that it peddled assiduously through the League of Nations.

The short of it was that the British convinced France, Holland, Sweden and most of Europe to keep their excess holdings of sterling exchange on deposit in the London money markets, rather than convert it to gold as under the classic, pre-war gold standard.

This amounted to a large-scale loan to the faltering British economy, but when Chancellor of the Exchequer Winston Churchill did resume convertibility in April 1925 a huge problem soon emerged.  Churchill’s splendid war had so debilitated the British economy that markets did not believe its government had the resolve and financial discipline to maintain the old $4.86 parity. This, in turn, resulted in a considerable outflow of gold from the London exchange markets, putting powerful contractionary pressures on the British banking system and economy.

Real Cause of the Great Depression: Collapse of the Artificial Boom

In this setting, Bubbles Ben 1.0 stormed in with a rescue plan that will sound familiar to contemporary ears. By means of his bond buying campaigns he sought to drive-down interest rates in New York relative to London, thereby encouraging British creditors to keep their money in higher yielding sterling rather than converting their claims to gold or dollars.

The British economy was thus given an option to keep rolling-over its debts and to continue living beyond its means. For a few years these proto-Keynesian “Lords of Finance” —- principally Ben Strong of the Fed and Montague Norman of the BOE—-managed to kick the can down the road.

But after the Credit Anstalt crisis in spring 1931, when creditors of shaky banks in central Europe demanded gold, England’s precarious mountain of sterling debts came into the cross-hairs.  In short order, the money printing scheme of Bubbles Ben 1.0 designed to keep the Brits in cheap interest rates and big debts came violently unwound.

In late September a weak British government defaulted on its gold exchange standard duty to convert sterling to gold, causing the French, Dutch and other central banks to absorb massive overnight losses. The global depression then to took another lurch downward.

But central bankers tamper with free market interest rates only at their peril—-so the domestic malinvestments and deformations which flowed from the monetary machinations of Bubbles Ben 1.0 were also monumental.

Owing to the splendid tax-cuts and budgetary surpluses of Secretary Andrew Mellon, the American economy was flush with cash, and due to the gold inflows from Europe the US banking system was extraordinarily liquid. The last thing that was needed in Roaring Twenties America was the cheap interest rates—-at 3 percent and under—that resulted from Strong’s meddling in the money markets.

At length, Strong’s ultra-low interest rates did cause credit growth to explode, but it did not end-up funding new steel mills or auto assembly plants.  Instead, the Fed’s cheap debt flooded into the Wall Street call money market where it fueled that greatest margin debt driven stock market bubble the world had ever seen. By 1929, margin debt on Wall Street had soared to 12 percent of GDP or the equivalent of $2 trillion in today’s economy.

As is well known, much economic carnage resulted from the Great Crash of 1929. But what is less well understood is that the great stock market bubble also spawned a parallel boom in foreign bonds—-specie of Wall Street paper that soon proved to be the sub-prime of its day.

Indeed, Bubbles Ben 1.0 triggered a veritable cascade of speculative borrowing that soon spread to the far corners of the globe, including places like municipality of Rio de Janeiro, the Kingdom of Denmark and the free city of Danzig, among countless others.

This is an excellent addition to both military and financial history. Be sure to read the whole thing; it’s close 10k words, but it is definitely worth the time and effort. This, in particular, is a key observation that underlines the falsity of the Keynesian narrative: “The Keynesians have never acknowledged the single most salient statistic about the war debt: namely, that the debt burden actually fell during the war, with the ratio of total credit market debt to GDP declining from 210 percent in 1938 to 190 percent at the 1945 peak!”

I’d noticed this myself in looking at total credit market debt, but never thought through the implications as Stockman has. One can even see it in the relevant chart posted in RGD.