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<font face="Verdana" size="1" color="#002864">http://www.mises.org/fullstory.asp?control=1363</font>
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<font size="2"><font face="Verdana" color="#002864" size="5"><strong>Reflation in American History</strong></font>
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<p class="MsoNormal"><font face="Verdana" size="4">By H.A. Scott Trask</font>
<p class="MsoNormal"><font face="Verdana">[Posted October 31, 2003]</font>
<p class="MsoNormal"><font face="Verdana"><img alt src="http://www.mises.org/images3/newdeal.gif" align="right" border="0" width="199" height="270">When
President George W. Bush took office in January 2001, the Dow had been in
decline for a year, the other markets since March. Within a month, the economy
officially fell into recession. Bush responded with a mix of Keynes (tax cuts
and higher government spending) and Friedman (cutting interest rates and
pumping up the money supply). During that year, the Fed cut the federal funds
rate 475 basis points, to 1.75 percent, and poured liquidity into the system
by openmarket operations. The same remedy was applied, but with ever stronger
doses, in 2002 and '03. Despite this heady dose of inflation, as well as
persistent efforts to"talk up" the economy, the recession persisted
into 2002 and the stock market continued to fall. The bust remained a bust,
and no amount of money magic could restart the boom.</font>
<p class="MsoNormal"><font face="Verdana">We have seen it all before.</font>
<p class="MsoNormal"><font face="Verdana">Since the early seventeenth century,
American governments (colonial, state, and federal) have tried and failed to
restart business expansions by reflation. That is, they have tried to
revive an inflation-driven economic boom that has stalled or collapsed by
pumping new money into the system. In other words, they have tried reflating
as the cure for the evils introduced by inflating. They have not yet
succeeded in skipping over the inevitable contraction of the business cycle,
but they have succeeded in worsening its severity and length and delaying
sound recovery.</font>
<p class="MsoNormal"><font face="Verdana">Writing in 1896, William Graham
Sumner, who had studied the history of American business cycles and the
political response to them, observed,</font>
<blockquote dir="ltr" style="MARGIN-RIGHT: 0px">
<p class="MsoNormal"><font face="Verdana">"For three hundred years our
history has been marked by the alternations of 'prosperity' and 'distress'
which are produced by the booms and their collapses. When the collapse comes,
the people who are left long on goods and land [and stocks] always make a
great outcry and start a political agitation. Their favorite device always
is to try to inflate the currency and raise prices again until they can
unload.... No scheme which has ever been devised by them has ever
made a collapsed boom go up again." </font>
[/i]
<p class="MsoNormal"><font face="Verdana">With characteristic pith, Sumner
pointed to the reason all such efforts had failed."The most far-reaching
vice in all these [inflation] schemes was that they led the people to believe
that the methods of a 'boom' could be successfully employed in the place of
the methods of thrift." In other words, the inflationists assure
everyone that there is no need to save in order to fund investment--just print
money and lend it out. Let us examine three case studies in the history of reflationism.
For the first two, Sumner shall be our guide, for the third, the great
Rothbard.</font>
<p class="MsoNormal"><font face="Verdana">Sumner noted that from colonial days
to the late nineteenth century periods of inflation were always followed by
slowdowns and complaints about a shortage of money. In 1715, <ST1:STATE>
<ST1:PLACE>
Massachusetts</ST1:PLACE>
</ST1:STATE>
issued 100,000 pounds of paper money. The economy boomed, and then it
floundered. By 1720,"there was a great cry for more bills. Let it be
observed how this complaint is heard again every four or five years, although
the amount of paper was continually increasing. It is the best instance in
history of the way in which a country 'grows up' to any amount of currency."
He coined a famous truism to sum up the lesson:"There can never be a
scarcity of currency except when there is too much of it."</font>
<p class="MsoNormal"><font face="Verdana">The <ST1:COUNTRY-REGION>
<ST1:PLACE>
United States</ST1:PLACE>
</ST1:COUNTRY-REGION>
experienced five major business cycles during the nineteenth century, each one
culminating in a financial crisis and depression. The second occurred during
the 1830s. From 1833 to 1837, the nation's money supply (specie plus bank
notes and deposits) increased by 78 percent, or nearly 20 percent annually.
The new money sparked a cotton boom in the South, a canal boom in the <ST1:PLACE>
Middle West</ST1:PLACE>
, and a land and real-estate boom everywhere. By early 1837, interest rates
began to rise as cotton planters and canal contractors sought to borrow more
capital to sustain their struggling projects. In the spring, a sudden
contraction in British credit and a fall in the demand for cotton paralyzed
the American economy. Large mercantile houses in <ST1:CITY>
<ST1:PLACE>
New Orleans</ST1:PLACE>
</ST1:CITY>
and <ST1:STATE>
<ST1:PLACE>
New York</ST1:PLACE>
</ST1:STATE>
failed. Interest rates skyrocketed. Prices plummeted. Thousands were thrown
out of work. In May, the banks suspended specie payments. The money supply
fell by 17 percent.</font>
<p class="MsoNormal"><font face="Verdana">For once, the federal government
wisely did nothing. President Martin Van Buren, a hard-money New Yorker,
blamed the crisis on the"excessive issues of bank paper" and an
"undue expansion of credit." His recommended course of action
was to let the liquidation run its course and for the government to cease
collecting or disbursing bank money and deal only in specie. To those
clamoring for tariffs, public works, and federal money, he replied dryly,
"All communities are apt to look to government for too much. This ought
not to be." </font>
<p class="MsoNormal"><font face="Verdana">However, the necessary liquidations,
debt reductions, and reallocations of capital were arrested by the untimely
intervention of the banks and the states. Taking advantage of the suspension,
they began inflating again. They were led by the former central bank, the Bank
of the <ST1:COUNTRY-REGION>
<ST1:PLACE>
United States</ST1:PLACE>
</ST1:COUNTRY-REGION>
, whose president, Nicholas Biddle, was determined to restart the boom by
borrowing funds in <ST1:PLACE>
Europe</ST1:PLACE>
and using it to buy cotton. The state banks were fully supported by their
governments, many of which authorized the illegal suspensions or refrained
from prosecuting the delinquent banks, and all of which continued to deal in
bank paper. The most indebted states even issued additional bonds. The money
supply increased by 8 percent in 1838 sparking a mini-boom. It did not last
long.</font>
<p class="MsoNormal"><font face="Verdana">Panic again struck in the fall of
1839. There was another run on the banks, and all of them south and west of <ST1:STATE>
<ST1:PLACE>
New York</ST1:PLACE>
</ST1:STATE>
again suspended payments. Sumner wrote,"This suspension was the real
catastrophe of the speculative period which preceded it. A great and general
liquidation now began.... The stagnation of industry lasted for three
or four years. The public improvements so rashly begun were suspended or
abandoned." Cotton prices again fell, as did the price of stocks
and real estate. Many banks failed entirely, including the powerful Bank of
the United States. States defaulted on their bonds, and canal companies and
other firms went bankrupt."The revulsion was so complete that it could
not be arrested until industry came almost to a standstill and took a fresh
start." </font>
<p class="MsoNormal"><font face="Verdana">The reason for the liquidation was
not that the banking system was incapable of providing sufficient liquidity
and credit to weather a crisis and restart the economy, but that huge debts
had been contracted in Europe, the canal system was overbuilt, too much land
had been brought into cotton cultivation, and land and real estate prices were
inflated because of inflation-driven speculation. For the next four years the
country paid the bill"for the grand times of the years before. It was
like the spendthrift living low to recover his position." The
country did it"by producing mainly for export, at prices low enough to
suit the creditors." By 1843,"a new sound and healthy
development of industry and credit began." </font>
<p class="MsoNormal"><font face="Verdana">In 1857 by contrast, neither the
banks nor the governments attempted to reflate the economy when another
stock-market crisis and bank run rocked the economy in the fall. President
James Buchanan, another hard-money Northerner, wisely did nothing."It is
apparent," he wrote in his first annual message,"that our existing
misfortunes have proceeded solely from our extravagant and vicious system of
paper currency and bank credits." For the next six months, the
money supply shrunk, interest rates went up, government spending stayed
constant, and businesses and banks were allowed to fail. The result? The
economy was in full recovery by the spring. However, Buchanan warned in his
next annual address that"these revulsions must continue to occur at
regular intervals" as long as the banks were allowed to inflate the
currency and extend credit beyond their actual capital reserve.</font>
<p class="MsoNormal"><font face="Verdana">One of the most powerful, persistent,
and pernicious historical myths is that the Great Depression of the 1930s
resulted from the laissez-faire policies of the three Republican
presidents of the 1920s. If students learn anything at all from college
history, besides that slavery was bad, and Hitler was really bad, it is
this. In Modern Times (1983), the historian Paul Johnson stated a
corollary of this myth. It is that President Hoover,"because of his
ideological attachment to laissez-faire, refused to use government
money to reflate the economy and so prolonged and deepened the
Depression." </font>
<p class="MsoNormal"><font face="Verdana">Of course, Hoover held no such
principles, and he did precisely what the myth faults him for not doing. <ST1:CITY>
<ST1:PLACE>
Hoover</ST1:PLACE>
</ST1:CITY>
was a corporatist, an inflationist, and a statist who tried every policy in
the interventionist playbook. He denigrated economists who urged him to follow
the examples of such laissez-faire presidents as Van Buren,
Buchanan, and Cleveland as"reactionaries" and"bitter-end
liquidationists" whose advice, if followed, would lead to"utter
ruin." Such a passive policy was not for the"great engineer."
<ST1:CITY>
<ST1:PLACE>
Hoover</ST1:PLACE>
</ST1:CITY>
did something. He declared"war" on the depression. It led to
utter ruin.</font>
<p class="MsoNormal"><font face="Verdana">Johnson's brilliant discussion of
this period is drawn directly from Murray Rothbard's revisionist masterpiece America's
Great Depression (1963). As Rothbard explains, Hoover tried all of the
following to revive the economy: tax cuts in 1930; higher tariffs (the
Smoot-Hawley tariff of 1930); deficit spending ($2.1 billion in 1931, and $3
billion in 1932); public works funding; subsidies for agriculture; propping up
wage rates; government loans to railroads, banks and financial institutions
through the Reconstruction Finance Corporation (1932); bank credit
liberalization by the Glass Steagall Act (1932); a huge tax increase by
the Revenue Act of 1932; and Fed pump priming. Johnson concluded,"That
he sought to use government cash to reflate the economy is beyond question." </font>
<p class="MsoNormal"><font face="Verdana">Free bankers and <ST1:CITY>
<ST1:PLACE>
Chicago</ST1:PLACE>
</ST1:CITY>
school monetarists, however, contend that <ST1:CITY>
<ST1:PLACE>
Hoover</ST1:PLACE>
</ST1:CITY>
and the Federal Reserve passively allowed the money supply to shrink and so
starved the economy of the funds and credit necessary to restart ailing
businesses and financial institutions. The truth is that the Federal Reserve
tried to inflate but was frustrated by the public's lack of confidence in the
banking system and by the bankers' reluctance to extend credit to marginal
enterprises. In the weeks and months after Black Monday, the Federal Reserve
both cut interest rates and poured liquidity into the banking system.</font>
<p class="MsoNormal"><font face="Verdana">By pumping up reserves, they hoped
to keep the credit boom going and revive the stock market. By the end of the
year, they had lowered the discount rate from 6 to 4.5 percent, purchased $375
million in government bonds, and lent member banks $200 million. Because of
these inflationary measures, the market began moving up again in November. The
<ST1:CITY>
<ST1:PLACE>
Hoover</ST1:PLACE>
</ST1:CITY>
administration did not neglect to"talk up" the economy. Secretary
of the Treasury Andrew Mellon boasted that there was"plenty of credit
available," and other officials, including the president, assured the
public that the crisis was over and the economy on the road to recovery.
Thanks to the Federal Reserve, of course. </font>
<p class="MsoNormal"><font face="Verdana">The Hoover Fed pursued the same
course in 1930. They cut the discount rate to 2 percent and purchased another
$218 million in federal securities. Despite these measures, the market resumed
its downward spiral and the money supply remained constant that year. Even
more vexing for <ST1:CITY>
<ST1:PLACE>
Hoover</ST1:PLACE>
</ST1:CITY>
and his new Fed chairman and fellow inflationist, Eugene Meyer, the money
supply actually shrank in the latter half of 1931, falling from $73.2 to $68.2
billion. Despite their efforts to pump reserves into the banking system
through Fed discounting and open market operations, banking reserves, and
hence the money supply, were shrinking. Industrial production was falling as
well. They just tried harder the next year.</font>
<p class="MsoNormal"><font face="Verdana">In the first half of 1932, the Fed
purchased $1.1 billion in federal securities and continued discounting
for the member banks. However, the money supply proved recalcitrant, falling
to $64.7 billion by the end of the year. Why? From the start of the
Depression, the Fed's efforts were frustrated by the public's withdrawal of
federal-reserve notes and gold from the banks. They had lost confidence in the
system and wanted to hold more cash. Second, the banks were reluctant to lend
out all their new reserves. As fractional-reserve institutions, they knew they
were vulnerable to a bank run. They also doubted the solvency of many of those
clamoring for more credit. It should be stressed that had the Fed not
intervened in the money and credit market the money supply would have fallen
even more. Furthermore, the money supply would have shrunk beginning in late
1929, instead of being delayed a full year by Fed pump priming. </font>
<p class="MsoNormal"><font face="Verdana">We can now answer the question of
why the Great Depression lasted so much longer (nearly ten years) and was so
much more severe than previous depressions. Of the five nineteenth century
business contractions, none lasted more than four years, and not one was
marked by the sustained high levels of unemployment and sharp drops in
industrial production experienced during the 1930s. If the monetarists are
right that stagnation in the growth of money caused the Depression to last and
grow progressively worse, then why did the far more immediate and significant
shrinkages in the money supply occurring after nineteenth century panics not
do the same? </font>
<p class="MsoNormal"><font face="Verdana">During those periods, there were
sharp reductions in bank deposits, bank notes, wages, and prices. Bankrupt and
marginal firms, farms, corporations, and banks failed in large numbers. Banks
called in loans and all but ceased new lending. However, within a short period,
business and production revived, and, although times would remain"hard"
for a number of years, people had little trouble finding productive work, or
surviving businesses and farms borrowing money at rates of interest that
reflected the supply of loanable funds and capital goods. What happened was
that capital and labor was redirected from overdone or unprofitable areas to
more productive and profitable ones.</font>
<p class="MsoNormal"><font face="Verdana">This did not happen after the stock
market crash of October 1929 because Hoover's proto-Keynesian fiscal policies
and inflationary monetary policies drove down interest rates, kept up wage
levels, prevented deflation, and delayed the liquidations and adjustments
needed to lay the groundwork for a sound recovery. That such would be the
result of Hoover's policies was recognized at the time by a number of writers
and economists quoted by Rothbard. For example, in August 1930, Dr. Benjamin
Anderson of Chase National Bank warned that the"depression has been
prolonged and not alleviated by delay in making necessary readjustments."
In 1933, Dr. Seymour Harris agreed that Hoover's policies had"retarded
the process of liquidation … and … accentuated the depression." </font>
<p class="MsoNormal"><font face="Verdana">It is too early to see the full
consequences of the Bush-Greenspan reflation, but if the past is any guide we
can expect the next decade to more resemble the 1970s than the 1990s.</font>
<p class="MsoNormal"><font face="Verdana"><span class="240075813-31102003">_____________________________</span></font>
<p class="MsoNormal"><font face="Verdana">Historian Scott Trask is an adjunct
scholar of the Mises Institute. </font><font face="Verdana">hstrask@highstream.net</font><font face="Verdana">.
See his </font><font face="Verdana">article
archive.</font>
</font>
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