Econoclasts: The Rebels Who Sparked the Supply-Side Revolution and Restored American Prosperity

Dr. Brian Domitrovic October 13, 2009 “Econoclasts: The Rebels Who Sparked the Supply-Side Loosemore Auditorium Revolution and Restored American Prosperity”

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H. James Williams: Good morning. Audience: Good morning. H. James Williams: I am James Williams, Dean of Seidman College of Business, and it is my pleasure to invite you here this morning to welcome you to Grand Valley State University and to a continuation of the economic analyses that we began last night over at Fountain Street Church. It seems that I just said goodnight to many of you last night, and so it is good to say good morning again. Before we get started, what I would like to do is what my colleague taught me last night. Cell phones – I am going to turn mine off, and I am going to ask you to do the same please. Well, the first thing we would like to do is just to get started with the introductions, but before we do, I would like to recognize the benefactors of this Peter Secchia Breakfast, so I will ask Peter and Joan to please stand so that we recognize you and show our appreciation for your great generosity. [clapping] What I would like to do now is just stand down quickly and ask my good colleague, Gleaves Whitney, who is director of the Hauenstein Center for Presidential Studies to please come up and get us started. [clapping] Gleaves Whitney: I tell you, last night was such a great success, and we are very proud of this partnership. Whenever you get the three names together, let me tell you – these three names meaning Seidman, Secchia and Hauenstein – you know something good is going to happen, because these are three individuals, three families, really in this community, who have made such a difference. And I am very proud of the fact that Dean Williams, Peter Secchia and Ralph Hauenstein and those of us who work in there, their names are honored and are able to put together a program such as the one you are enjoying today. It is my pleasure to introduce our keynoter this morning. Brian Domitrovic holds a PhD from Harvard University, and he asked me to hold up his most recent book Econoclasts, which is available outside now. Now, Brian did a great service in this book. I started reading it and what is amazing about it, no one has told the story of really, this could be called the beginnings of the rating revolution really in a sense, and no one had written a story this way, so I highly recommend this book to you. Let me tell you a little bit about Brian. He is originally from Pittsburgh. He got a Bachelor’s Degree in Mathematics and Economics and Columbia University before going to Harvard, and then he went to Sam Houston State University outside of Houston, Texas, where he teaches. Houston is my home town, so we have a neat connection there, and he is learning that Houston has snow regularly, once every 14 years [audience laughter]. But what I would like to do at this point now is invite Brian to come up and talk about his book, and he will challenge us I think very much and set the tone for today’s debate. Brian… [clapping] Dr. Domitrovic: Thank you very much, Gleaves. It is great to be here. I last saw Gleaves one year ago at the Founder’s Breakfast for Free Enterprise Institute Center for the American


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Idea at the Rose Country Club in Houston and he did a great job on the keynote address there. What I would like to talk about today is a subject that is taken up in my book, Econoclasts, which is a history of supply side of economics which of course culminated in the new rate revolution in the early 1980s and restoration of American prosperity. Supply-side economics was born in the 1920s as a result of the Great Depression that did not happen, that of 1919 to 1921, and what I would like to do today is simply discuss why the Great Depression happened in the early 30s and not in the early 20s when the conditions were just the same. We used to think that capitalism caused the Great Depression. Back in the 1950s, when John Kenneth Galbraith was running, it became a common view that corporations, stock traders, the market in a word, caused the incredible down turn of the early 1930s, whereby industrial production fell by a third and unemployment displaced fully one quarter of the national work force. It was a crisis of capitalism, as the Marxists were prone to say. “The massive literature on the causes of the Great Depression has generated more heat than light,” so said economist Robert Mundell, as he accepted the Nobel Prize in December of 1999. Mundell was right. All the literature hanging the Great Depression on a crisis of capitalism was misplaced. Here is what we now know. The fingerprints on the Great Depression, and what caused it are all those of the government. The chief compass, probably the sufficient compass in the Aristotelian sense of the Great Depression, was in particular the way the Federal Government bungled its management of the gold standard. Let me restate – this strange bird is bungling the gold standard was the sufficient compass of the Great Depression, or as Mundell again said in the 1999 Nobel Prize address, “had the United States raised the price of gold in 1928, there would have been no Great Depression, no Nazi revolution and no World War II.” It was the greatest financial mistake in modern history, and the Federal Government of the United States is the one who made it. Over the next twenty minutes, I would like to explain this argument. The argument follows the life’s work of Robert Mundell, the founder of supply-side economics, the nobelist, and the greatest hallucinator of this argument. Mundell’s work in turn was based on economic research done in the 1920s, yet ignored at the time. Work done by such figures as Ludwig von Mises, Gustav Cassel, Charles Grist, John Clark Young and even John Maynard Keynes. Let’s begin by taking a step back. Knowing why the Great Depression happened can only occur if we look into an earlier period and ask why the Great Depression did not follow World War I. The root cause of the decision that precipitated the Great Depression in the 30s, the bungling of pricing gold after 1929, this root cause itself was another U.S. mistake, particularly on the part of the rookie Federal Reserve a dozen years before during the period of U.S. neutrality in World War I. Let me take you back to that time. From 1914 to 1916, while the European countries were at war in the Ottoman Empire and the U.S. was not, Europe bought an inordinate stock of goods from the United States. However, the United States bought nothing from Europe in return, because, being at war, these countries were not producing things for sale. Therefore, in those two years, the United States took the logical move on gaining so much European currency that had no promise of buying goods and services


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and redeem those currencies for gold with the respect of currency issuers, the European country support. What happened in that stand is that a great part of Europe’s monetary gold stock migrated to the United States and indeed to other neutral nations who were not fighting World War I such as Argentina, Spain, Japan, Holland and Switzerland. In the space of two years, just two years, 1914 to 1916, the monetary gold stock of the United States doubled. Here the Federal Reserve, a green institution, green in the old sense that is to say it was a rookie, having only been born right before the war started in late 1913, made a momentous and flawed decision. The Fed chose to print dollars corresponding to the new gold coming in to the U.S. From 1913 to 1919, the quantity of dollars issued doubled just as the quantity of U.S. monetary gold doubled. The effect of this decision was to double one thing more – the price level. From 1913 to 1919, the consumer price index increased by 102%, much of it before U.S. entry into the War in spring 1917. This was the only example of peacetime inflation in the United States to date. The holders of gold, and these included many average Americans, all of this was an outrage. If you had an ounce of gold in 1913, you could get $20 from the U.S. Treasury, then the government’s official conversion rate. And in 1919, for that same ounce of gold, you could still get $20 for it from the Feds. The $20 in 1919 could buy you half as much stuff as in 1913. By doubling the dollar stock in the face of the remarkable gold influx and creating a mega inflation, the United States had unwittingly halved the real value of all monetary gold. This was a mistake. In 1919, six years into its existence and beginning to its get sea legs finally, the Federal Reserve realized it had made a considerable blunder – this inflation and this halving the real value of gold. So it tried to undo its mistake. From 1919 to 1921, the Federal Reserve proceeded to suck dollars out of the economy. It did this by various means – raising interest rates, raising bank reserve requirements, sterilizing new gold influx. The results came fast and hard. Prices dropped. A deflation by 25% - meaning that the Fed was half way there towards gaining back the 1913 price level. But you see with this mega now deflation after 1919 meant for the economy. Nobody wanted to spend money. By holding money, you got richer. A lot richer. By taking the price level which was at 10 in 1913 from 20 to 15, from 1919 to 1921, the Fed made sure that people who held but did not spend dollars saw the value of those dollars increase by fully one third which is 20 divided by 15. With the Fed giving every indication that this deflation policy was going to be maintained until the price level hit 10 again – the 1913 level – there was all the more reason to hold and not spend your currency, for 15 divided by 10 is 50%. If you deferred purchases until the Fed was finished, your money would quickly appreciate by half, so nobody spent anything. And from 1919 to 1921, the United States had the worst depression in its history. Unemployment, which hadn’t even been a word twenty years before, hit 15%, perhaps 20% as Amity Shlaes said last night. Easily 50% higher than in any previous economic crisis. Massive strikes occurred, even though there were no unions, and all the blame was put on foreign agitators as the likes of Emma Goldman were deported and packed off to the old world. It wasn’t foreign agitators. The only reason the incredible recession was occurring was that the Fed, of its own accord, was engineering a historic deflation. Finally, intelligence stepped in. New York Fed President


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Benjamin Strong finally got hold of the board and told them to cut it out. In 1921, new treasury secretary, Andrew Mellon, the Pittsburgh banker extraordinaire who new a thing or two about keeping businesses going, supported Strong’s position. And he had Harding’s support and Harding should be considered perhaps a great President for hiring Mellon. Both men, Mellon and Strong, implored the money master of the Fed to stop deflation and inflation – just keep prices stable at whatever level they happen to be at that point for the future. At the moment, this was where consumer price index was at 16, or 60% higher than it 1913. Keep it at 16 forever, Strong and Mellon said. The economy works best with permanently stable prices. If the CPI, the inflation rate, goes over 16, tighten money; if below 16, loosen money. Inflation, deflation target these, you greenhorns, Strong and Mellon told the Fed. The Fed sheepishly took the advice and kept the price level at precisely 60% over the 1913 mark for the next eight years until late 1929. I don’t think I need to tell you we now know what happened in that span of those eight years, in the wonderful hard and foolish years. “It was simply the bright period in all American economic history,” as economic historian Richard Vetter has written of the roaring 20s. Economic growth was 4.5% per year from 1922 to 1929, an incredible sustained level, and when you participated in this great bonanza, you really did, because prices stayed the same. Now, some of you might be thinking, based on what I said a few minutes earlier, hold it. If you held gold, you were still getting the shaft. In 1913, an ounce of gold could buy $20 worth of stuff given the official U.S. conversion price of $20 per ounce of gold which never changed through the teens and the 20s. But $20 was worth less in the 1920s compared to 1913 because the price level was up by 60%. $20 in the 1920s could only buy $12.50 worth of stuff of 1913 prices. So if you had been holding gold, you were still losing pretty badly. Well, one further reform should have taken place in 1921, or for that matter, at any point during the roaring 1920s, but did not. The U.S. should have raised the official conversion price of gold by 60%. During the roaring 20s, no one much cared about this oversight because you wanted to get out of gold and into the dollar. The dollar could be used to buy investments on the market place but gold could not be so used, and with the stock market going up 400%, you wanted to be in the means which change the currency which you had used to buy stocks as opposed to gold which cannot regularly be used to buy securities unless converted into currency. However, once a little pause in the market might occur, you might think about quickly exchanging currencies for gold, because the U.S. still had to get around to correcting the old mistake and raising the official price of gold by 60%. You could ride the market until it paused, quickly cash out, buy gold and wait for a nice 60% appreciation on that investment in gold. Without a pause in the market, however, there would be too many stock gains still on the table for people to get out and cash in dollars for gold. For I think it is time we admit it, and there were clear suggestions of this last night. The 1929 stock market crash was merely a pause, not a crash. Through the calendar year of 1929, the Dow was flat. And from January 1, 1929 to April 1930, it was positive; that’s no crash. It was a pause. The crash was from April 1930 until June 1932. And remember, stock volume in the summer of 1929 peak was small. All the brokers were on vacation. Well, the pause in 1929 which should have happened, did happen. People started cashing out dollars for gold expecting a price spike, and then oddly, there was a repeat of 1919 to 1921. The Feds suddenly switched its price stability and policy of 1922 to 1929 and went back


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to what had failed a decade earlier. The Fed tried heroically, stupidly, to reclaim the 1913 price level. This obscure mistake is the single most catastrophic decision the Federal Government in all its branches has ever made. The Feds defense of 1913 prices in the wake of 1929 stock market event guaranteed not only a major deflation again but a mass evacuation out of the means of exchange. If the Fed held to this policy for any length of time, a depression on the order of 1919 to 1921 or worse, had to ensue. That the Fed didn’t adhere to this policy from 1929 to 1933, is a prime reason that the house history, of Federal Reserve, the house history, the commission, by economist, Thomas Alan H. Meltzer of 2004 begins with these words: “The founders of the Federal Reserve did not intend to create a powerful institution. Had they been able to see the future, they would not have acted in 1913.” After the so-called crash thing in 1929, the Fed raised interest rates and made other moves indicating that it was interested in erasing that extra six points on the price level. People got the hint, went to the back, got out dollars and cashed them in for gold at $20 an ounce. That is to say, a game of chicken ensued. Surely, it was madness, and it was madness, for the Fed to engineer a 40% deflation over a period of several years. For its recent experience had clearly shown, a dozen years before, this would stop consumer demand in its tracks as people chose to hold currency and refused to buy because currency is appreciating in value. Because it was abundantly clear after 1929 that all sense indicated the Fed should once again, as in 1921, drop its fool deflationary policy and keep the price level where it happened to be for the future. This left the Government with only one realistic thing to do – raise the price of gold for the love of God. The Fed refused to do so. It said, darn it, we are not going to prove all of you right, and we are going to get the price level down to the 1913 mark so that gold will be correctly valued once again at $20 per ounce. There you have your Great Depression. Sure enough, 1919 to 1933, prices declined by a third and consumer demand, as can only be natural, completely dried up. Banks saw their deposits rated because all reasons suggested one would still be well positioned in gold. That is to say, surely the Fed is going to quip austerity and concede to stable prices in a permanent increase in the price of gold as everyone was expecting. Does that make sense? The problem quickly got worse than in the decade before. This time, in the early 30s, the Government chose to deficit spend to counteract the recession engineered by the Fed. Hoover’s deficits hit a whopping 5% of GDP per year by the end of his term. The problem with running deficits in deflationary periods is that the value of those deficits, they’re my source, and it becomes difficult for governments to make payments on them. Deflation increases the value of government deficits. In the early 1930s, the United States was therefore wondering if it might default as deflation appreciated the size of Hoover’s big deficits by 40%. Now this was different from 1919 to 1921. Then, the U.S. was barely running a deficit, so it did not have to worry about its service payments going up massively in case of deflation. Under Hoover, however, the deficits were large and service on them stood to be paid in future years in currency worth 40% more than in 1929. The government would have to rake in revenue beyond all comprehension to make those payments. Therefore, in the early 1930s, but not in 1919 or 1921. There came massive tax increases. The top break of the income tax quickly went from 25% to 63% and then to 73%. The Revenue Act of 1932, by all accounts, was the most massive comprehensive tax increase in American history.


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You see the strange logic. The Fed and Treasury causing deflation, the purpose of which is to justify a $20 price of gold. The deflation in turn causes a sharp recession because people hoard appreciating currency instead of spending it. To counteract this government-caused thing, the recession, the government deficit spends – Keynesianism, a powerful lens – indeed sponsored by Hoover. But the financing of the deficits in this context, is so challenging because of deflation, that simply unheard of tax increases are required to keep the deficit within reasonable grounds. So, huge tax increase result, but all these do is kill the business activity that the deficit had sought to stimulate in the first place. Public work stimulus and tax increases cancelled themselves by 1932, so the fate of the economy was in the hands of the currency master would continue to insist still on the $20 price of gold and continue to force the overall price level back down to the 1913 mark in the service of this objective. Amazingly and unconscionably, the answer was yes. Even Britain, which had done the same thing in trying to appreciate its currency after 1929 to make good on the pounds 1913 redemption rate being gold, gave up in September 1931 and announced the pound was no longer on gold. The U.S. continued to defy speculation against the dollar by keeping the official gold conversion rate at $20 and beating down the overall price level, getting it ever closer to the 1913 mark in deflation. When FDR took office in 1933, he showed he understood the issues at stake about as well as Hoover had. FDR suspended the dollars converted ability to gold in 1933 in imitation of British in a move that made some sense but only a little bit. But then, incredibly, FDR announced that it would soon be illegal for Americans to hold gold, and he set a deadline. All Americans would have to sell all their gold to the government at the old rate of $20, the going rate. If you had bought expecting a price spike, you weren’t going to get it because gold holding was quickly becoming illegal. Some Americans dutifully and lawfully gave up all their gold – one of the most fascistic examples of all American history – in exchange for $20 for every ounce. Then, incredible, the next year, in 1934, FDR raised the gold conversion ratio to $35 an ounce. The very move, the thought of which, had caused the five-year flight out of currency to begin with, indeed which had caused the Great Depression. The Federal Government’s 75% increase in the dollar conversion raised to gold in 1934 is itself sufficient evidence to indicate that the Great Depression came about essentially to court because this move could have not been made five years earlier. What if, after all, immediately in the wake of the 1929 stock market pause, the United States had raised the gold price from $20 to $35 an ounce? There would have been no massive move out of stocks and bank deposits because the alternative to currency, gold, would have already experienced its resounding price increase. That the United States remained imperious about the old gold price after 1929, for five long years, and tried to make that old price credible for those five years from 1929 to 1933, is why we got the Great Depression. And indeed, after 1934, the U.S. resorted back to the Mellon and Strong price stability policy. The price level moved not a wit from 1934 to 1940. Hence, you saw a return of growth to the economy in those years. The growth was not as good by any stretch as in the decade before, because the high tax structure set up by Hoover was there to damp down the economy as soon as it got going. There was also the residual effect of the Smoot-Hawley Tariff which in 1930 had tried to help out firms getting killed by the dollar appreciation by shutting out foreign competitors.


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So, you see the fingerprints on this travesty. The Great Depression that gave way to the most hideous and destructive war in history. The cause of this Great Depression, if taken to a crime lab, comes back as Government, Government, Government – fingerprints, DNA, everything. Everything except motive of course. There was no maliciousness here, just incompetence and lack of perspective. We now know that permanent price stability is imperative for the economy to function well and to grow. If you are on a gold standard and you make a mistake and print too much money, by all means, raise the price of gold and commit to price stability at the new high level for the future. This was the lesson half learned in 1921. The U.S. stopped its crazy deflation half way through erasing the 1913 and 1919 inflation of 100%. That was an excellent move, stopping for deflation, and it kept prices staying at the new par for the next seven years, seven stupendous years, that are among the greatest in the economic history of the world. In addition, the Government should have made one more correction and increased the price of gold by 50%, commensurate to the increase in the overall price level that was being conceded. And in every moment after 1929, the U.S. had the opportunity to do this, to raise the price of gold to staunch the flight from currency, and it took five years to see the light. Again, this is one of the worst episodes in decision making in the modern history of government. The lessons for today are fairly clear. First, government, not business, causes any economic crisis as time indicates 2008, 2009, will indicate. Second, price stability is imperative. Most regrettably today, the common view including in the halls of power, is that capitalism caused the current crisis. This is dead wrong. Massive instability in the means of exchange, the dollar, occasioned by Alan Greenspan’s last years at the Fed, caused this crisis as is the considered opinion, and this is a little known fact, of a majority of the world’s top macro economists led by John V. Taylor and Andrew Schwartz. Today, we should recommit to keeping the dollar stable in terms of its domestic purchasing power as well as its rate of exchange to other major currencies. This in itself will allocate resources towards priceability, will allocate resources towards real economic enterprises to a great degree. In addition, we should be the opposite of the fiscal and trade measures taken in the 1930s. We should cut taxes, restrain spending and encourage world trade. Does that sound to pat for you? Think about it. What if right now the U.S. took dedicated action to keep the dollar stable, taxes low, spending moderate and trade open? Right now. Needless to say, we would put our current prices to pasture forthwith and start giving the roaring 20s some competition for the laurel of the most stupendous episode of noninflationary growth and across the board prosperity the eye has ever seen. Thank you. [clapping]

Documents

Econoclasts: The Rebels Who Sparked the Supply-Side Revolution and Restored American Prosperity