The Shape of US Populism

Henry C.K.  Liu

Part I: Legacy of Free Market Capitalism
Part II: Long-term Effects of the Civil War
Part III: The Progrssive Era
Part IV: A Panic-Stricken Federal Reserve

Part V: The Great Depression, the New Deal and the 2007 Credit Crisis

This article appeared in AToL on May 21, 2008

More than two years after the October 1929 stock market crash, a commission originally established by the Republican-chaired Senate Banking and Currency Committee to prepare official Republican defense for the upcoming presidential election finally began hearings in March, 1932 in the depth of the ensuring depression to examine the causes of the market crash and to recommend reforms to prevent future recurrences. During the eight months leading up to the 1932 presidential election in November, with an upsurge of populist sentiments caused by two years of severe economic pain, Democrats predictably criticized the original commission for whitewashing Republican policy responsibility in causing the financial crisis and in failing to prevent the market crash from turning into the resultant economic depression.

The political dynamics in 1932 has similarities with that of the upcoming 2008 presidential election in the aftermath of the credit market crisis that broke out in August 2007. The main difference between 1932 and 2008 is that, unlike in 1932 when Democrats could disclaim policy responsibility for the 1929 crash, they cannot deny in 2008 the policy responsibility of the two-term Clinton administration (1993-2001) for the credit bubble that burst in 2007. Another difference is that the full impact of the final bursting of the serial bubbles would not be fully felt until after the 2008 election. The 1932 election was held in the midst of a severe depression.

The Implosion of Rubinomics

It was Robert Rubin, special economic assistant to President Clinton and later Treasury Secretary, who worked out what has come to be known as Rubinomics, the strategy of dollar hegemony through the promotion of unregulated globalization of financial markets based on a fiat dollar that also forced deregulation on the US financial market. See my April 11, 2002 AToL article: Dollar Hegemony.

The argument that financial market regulation would reduce US competitiveness because it would force US financial institutions to relocate overseas had assumed an air of immaculate logic in the ideological context of neo-liberal globalization during the Clinton years. That neo-liberal mentality set the stage for US government abdication of regulatory responsibility over the financial sector and allowed the free market to move towards the inescapable path of eventual self-destruction, despite historical experience of the Roaring Twenties and the New Deal having shown the need for regulation to rein in the suicidal excesses of financial free markets.

The neo-liberal strategy was set in motion with the help of an ever-accommodating Federal Reserve to supply more liquidity to foil even the slightest stock market correction on what Fed chairman Alan Greenspan observed as “irrational exuberance”. Since for almost two decades the finance sector had grown faster than the real economy, most of the excess liquidity injected by the Fed went to develop serial debt bubbles that simply got bigger and bigger each time through financial innovations. These ever bigger bubbles were generated by increasingly sophisticated and complex debt instruments that carried synthetic credit ratings structured in linked hierarchies of risk exposures and marketed worldwide as “safe” investments to supposedly nondiscretionary conservative institutional investors managing money of clients who normally were not in any position to take such risks. Such triple-A rated “safe” investment-grade instruments were theoretically protected by a solid base of large number of dispensable financial frontline yeomen instruments. The structured finance regime nevertheless mandates that when enough of the frontline yeomen die, the lords who depend on a tolerable yeomen survival rate for protection also fall into jeopardy.

Both the Greenspan Fed and the Clinton Treasury Injected Excessive Cash into the Bubble Economy

Through much of the Clinton administration, the Greenspan Fed kept short-term interest rate too low for too long for a healthy economy, notwithstanding the alleged safety provided by sophisticated hedging of risks. Towards the end of the Clinton presidency, an abnormal term structure on interest rates was created in early 2000 by the Greenspan Fed finally raising short-term Fed funds rate targets to fight inflation while the Treasury under Larry Summers was pushing down long-term rates by buying back 30-year Treasury bonds with funds from a Federal budget surplus derived from a debt bubble, flooding the market with excessive cash.

Silly Talks of the End of the Business Cycle and the Goldilocks Economy

As all market participants know, an inverted rate curve is a classic signal for recession down the road. Yet silly talk of the “end of the business cycle” was extravagantly entertained by neo-liberal government economists, along with silly talk of the “end of history” by neo-conservative superpower strategists. The so-called “goldilocks” economy fantasy of not too hot, not too cold, but just right, was born, along with the superpower fantasy that goldilocks will pay for costly foreign wars of moral imperialism around the world without hurting the domestic economy. Goldilocks was called upon to provide the US with both guns and butter.

George W Bush won the November 2000 presidential election along with the bursting of the Clinton debt bubble. The Greenspan Fed again came to the rescue by turning on the fiat money spigot to fund a housing bubble mistaken as a miraculous boom, applauded by a grateful Congress overtaken with unquestioning awe and blind adulation normally reserved only for living gods. See my February 24, 2004 article in AToL: The Presidential Election Cycle Theory and the Fed.

The policy of moral imperialism brought spectacular terrorist attacks on the US homeland, forcing the Bush administration, less than nine months in office, to turn Clinton’s foreign war of moral imperialism into a global war on terrorism that some have estimated will cost up to $2 trillion or 20% of US GDP, a cost even a goldilocks economy cannot afford. The 9-11 2001 terrorist attacks on the US homeland gave the Fed a convenient excuse to flood the market with massive liquidity. The goldilocks economy got a new lease on life from the global war on terrorism, allowing structured finance to blossom as a regime of global financial terror. The destruction of 911 goes pale against the still unfolding destruction of the 2007 credit crunch.

The Political Repercussions of the Great Depression 

Back in the 1930’s, the Great Depression that followed the 1929 market crash had direct political repercussions. In the 1930 mid-term elections, the Democrats gained control of Congress, and in 1932, Democratic candidate Franklin D. Roosevelt was easily elected president over Republican incumbent Herbert Hoover, carrying over 40 states. The Democrats finally gained control of both Congress and the Executive Branch after more than a decade of Republican rule.

Findings of Pecora Commission

The new Democratic chairman of the Senate Banking and Currency Committee, Senator Duncan U. Fletcher of Florida, immediately dismissed the Republican general counsel of the Commission on the 1929 Crash and appointed as replacement Ferdinand Pecora, an assistant district attorney for New York. Known thereafter as the Pecora Commission, its new investigation after 1930 revealed a host of conflicts of interest in the financial sector in the years leading up to the 1929 crash, such as bank underwriting of unsound securities to save near non-performing bank loans, rampant insider trading and “pool operations” by speculators banding together to move a stock and to close out the pool at peak price for profit, leaving the manipulated public with subsequent losses.

More shocking still, the Pecora Commission uncovered the embarrassing fact that JP Morgan and his fellow banking titans not only continued to reap huge profit from rescuing firms they helped put in distress while the economy fell into severe depression, but they were also able to avoid paying any income tax in 1931 and 1932 through tax loopholes on paper losses of distressed companies they acquired. These bankers were in fact buying up a country in economic distress with their tax deductions.

Revival of Populism: Henry George and the Single Land Tax

The excesses of the Roaring Twenties revived populist calls for reform and even radical demands for revolutionary systems of taxation. The Robert Schalkenbach Foundation (RSF) was organized in 1925 to promote public awareness of the social philosophy and economic reforms advocated by Henry George (1839-1897), centering around the “single tax on land values” first published in The Christian Advocate in 1890.  The Henry George Foundation of America was formed in 1926 as a non-profit entity by some of the leading luminaries of the progressive wing of the Democratic Party in Pittsburgh, Pennsylvania.

According to the RSF web site, “George began with the ethical premise that all people have an equal right to the use of the earth. From that he concluded that exclusive private ownership of land (natural resources) creates unwarranted special privileges. Furthermore, he observed that holding land out of production drives down [both] real wages and returns to capital equipment [as distinct from capital per se].  This process is further exacerbated by taxes on production and income that 1) increase unemployment, 2) discourage productive investment, and 3) encourage unproductive land speculation and rent-seeking.  To counteract this self-destructive system, George advocated shifting taxes from labor and capital onto the value of land and natural resources.”

Riding on a wave of populism, George ran, though unsuccessfully, twice for mayor of New York, the first run in 1886 when he came in second ahead of a young Theodore Roosevelt.  George died in the midst of his second run in 1897 at age 64. Between elections, he traveled around the world promoting his vision of economic justice, influencing many reformers. In pre-revolution Russia, George’s ideas were popularized by Leo Tolstoy, and in China by Sun Yatsen, the leader of the revolution that overthrew in 1911 the 267-year-old Qing dynasty.  George’s grand daughter was the celebrated American choreographer Agnes George de Mille.

Socio-Economic Darwinism

The 1920’s were a time of revival for 1860’s socio-economic Darwinism manifesting itself through laissez-faire market capitalism which condones no-holds-barred competitiveness not just for economic growth but for corporate survival. It denied the early American communal spirit of cooperation. Big business adopted the “survival of the fittest” theme of English sociologist Herbert Spencer and Yale professor William Graham Sumner with self-righteous morality. Yet survival of the fittest among the animal kingdom is practiced only between species, while intra-specie cooperation is the general law. The symbiotic interdependence of different species is well recognized in all ecological systems. Moreover, the laissez-faire market system is far from a natural phenomenon, but a contrived mechanism with the purpose of reconciling individual pursuit of self interest with the welfare of society. It was becoming clear that this reconciliation was again failing in the 1920s and it had been in the 1860s.

Other Populist Voices: Ward, Veblen and Bellamy

Reacting against economic individualism, other populist voices beside Henry George included Lester Frank Ward (1841-1913), Thorstein Veblen (1857-1929) and Edward Bellamy (1850-1898).  Ward asserts that man should use his intelligence to control and direct his future, making a distinction between the “telic” and the “genetic”, insisting that there is “no natural harmony between natural law and human advantage.” Thus laissez-faire market capitalism does not necessarily promote human progress, and when it runs amuck, could pervert economic progress to reverse human progress in civilization. Ward’s views paved the way to positive socio-economic planning by government that the Progressive and the New Dealers promoted.

Veblen published The Theory of the Leisure Class in 1899 in which he separates industry, the production of wealth, from business, the acquisition of wealth. Veblen coined the term “robber Baron” to describe the titans of business in the 1860s and also the term “conspicuous consumption” to describe the behavioral pattern of the nouveau riches.

Bellamy advocated a state socialism based on Christian ethics. His best-selling utopian novel: Looking Backward, became influential and sparked the formation of the “Nationalist” political movement and several accompanying utopian living experiments during the 1890's. By late 1888, the first of the Bellamy Nationalist Clubs was formed and the movement soon spread across the country. The main purpose of the clubs was to create and promote the practical realization of Bellamy’s utopian vision. Members became involved with other reform political groups and the Nationalists were represented at the 1891 Populist Party convention. Eugene Debs, the up and coming Socialist leader, also advocated some of Bellamy’s programs. However, the Nationalist movement stressed an evolutionary not revolutionary approach to social change. A small group of educated leaders, not masses of laborers or workers, would usher in the new society. This attitude alienated some of the more radical Socialist and Populist supporters of Nationalism. Despite temporary solidarity with these groups, the Nationalist movement lost popularity and was essentially defunct by 1894.

Populism and New Security Laws

With a backdrop of such populist ideas, the 1932 hearings and findings of the reconstituted Pecora Commission galvanized broad public support for new securities laws. As a result, Congress passed and Roosevelt signed into law the Security Act of 1933, referred to as the “truth in securities” law, with two basic objectives: 1) require that investors receive financial and other significant information concerning securities being offered for public sale; and 2) prohibit deceit, misrepresentations, and other fraud in the sale of securities.

Congress also passed in 1933 the Glass-Steagall Act, which mandated a separation of commercial banks that took deposits and extended loans, from investment banks that underwrote, issued, and distributed stocks, bonds and other securities. The House of Morgan had to split into JP Morgan Bank, a commercial bank, and Morgan Stanley, an investment bank to satisfy Glass-Steagall, even though both were still controlled by Morgan.

The next year, Congress passed the new Security Exchange Act of 1934, creating the Securities and Exchange Commission (SEC) to protect the interests of the small investor. The Act empowers the SEC with broad authority over all aspects of the securities industry, including the power to register, regulate, and oversee brokerage firms, transfer agents, and clearing agencies as well as the nation‘s securities self regulatory organizations (SROs). The various stock exchanges, such as the New York Stock Exchange, American Stock Exchange and National Association of Securities Dealers which operates the NASDAQ system are SROs.

Joseph P Kennedy, First SEC Chairman 

President Roosevelt appointed Joseph P. Kennedy as first chairman of SEC.  Kennedy was a highly successful speculator on Wall Street with a wide network of business dealings, not all of which were respectable if not outright illegal, whose appointment Newsweek described as “a former speculator and pool operator will now curb speculation and prohibit pools.”

Unlike other run-of-the-mill speculators, Kennedy had farsighted political vision which he realized by the shrewd use of his considerable wealth gained from market tactics that he was now responsible for policing. In his first speech as SEC Chairman, Kennedy pronounced a new populist path for the stock market: “The New Deal in finance will be found to be a better deal for all.”  Kennedy’s populism paved the way for his son, John F. Kennedy, to the White House three decades later in 1961.

Bill Clinton’s Rejection of the FDR/Kennedy Populist Tradition

Ironically, another Democratic president, Bill Clinton, elected on a populist platform in 1992 another three decades later, repealed in 1999 Glass-Steagall that had created the SEC. The Front Line program of Public Television produced a documentary detailing the role of Clinton Administration in The Long Demise of Glass-Steagall.

On November 12, 1999, President Clinton signed into law the Gramm-Leach-Bailey Financial Services Modernization Act which repealed the Glass-Steagall Act of 1933, to allow commercial & investment banks to re-consolidate. The repeal of the Glass-Steagall Act, by combining the conflicting roles of lending institutions and security issuing institutions, facilitated the development of structured finance and debt securitization that contributed structurally to the 2007 credit crisis.

Phil Gramm, Populist turned Neo-liberal Republican

Phil Gramm, who began his political career as a Democratic congressman in the Texas populist tradition, changed party affiliation to become a neo-liberal Republican senator from Texas. As Republican chairman and ranking member of the Senate Banking Committee, he spearheaded the Gramm-Leach-Bailey Act of 1999 with the conviction that higher bank profits commensurate with higher risk is the salvation of the economy, reversing the age-old principle that banks should be the most risk-averse institution in the economy.

Between 1995 and 2000, Gramm received over $1 million in campaign contribution from the securities and investment industry, more than he received from oil and gas interests that traditionally were a key source of financial energy in Texas politics. After retiring from politics, Gramm became vice-chairman of the investment banking arm of Union Bank of Switzerland (UBS), an institution currently in the spotlight for massive losses from subprime mortgage exposure. Gramm has been an economic adviser to the presidential campaign of Republican candidate John McCain since summer 2007. Also, he is rumored to be one of several possible running mates to McCain for 2008.

Enron Controversy

Gramm became linked to the Enron scandal when it came to light that his wife Wendy, while serving on the Commodity Futures Trading Commission, was involved in granting an exemption for Enron from federal oversight, immediately after which she was named a director at Enron. It came to light later that Gramm had helped to turn the regulatory exemption into law as well as push through the deregulation of energy markets that led to the Enron scandal. During this period, Enron was a major contributor to Gramm’s political campaigns.

Populist Litigation Against Enron Fraud

The University of California, lead plaintiff for an investors class action in the Enron securities litigation, obtained court approval of a settlement reached on October 6, 2004 with certain of Enron’s former directors in which the investor class received $168 million, consisting of $155 million in insurance proceeds and more than $13 million in personal contributions of insider trading proceeds by Enron directors, including Wendy Gramm.

Pursuant to the agreement, the $200-million remaining balance of Enron’s directors and officers insurance policy was paid into the registry of the court and the personal contributions of the directors, totaling over $13 million, was deposited in trust with class counsel.

The agreement marked the fourth settlement in the case, totaling almost one-half billion dollars already recovered for the class. UC reached a $222.5-million settlement with Lehman Brothers in October 2004, a $69-million settlement with Bank of America in July 2004, and a $40 million settlement in July 2002 with Arthur Andersen’s international umbrella organization that released Andersen Worldwide SC and its non-US member firms from liability and dismissed them from the suit. Arthur Andersen’s US arm, which served as Enron’s auditor, remains a defendant in the case. On December 15, 2004, a unanimous three-judge panel of the US Court of Appeals for the Fifth Circuit, sitting in New Orleans, upheld the Anderson Worldwide SC settlement.

The defendants in the shareholders’ lawsuit included the financial institutions of J P Morgan Chase, Citigroup, Merrill Lynch, Credit Suisse First Boston, Canadian Imperial Bank of Commerce, Barclays Bank, Toronto-Dominion Bank and the Royal Bank of Scotland, all considered key players in a series of fraudulent transactions that ultimately cost Enron investors billions of dollars. Other defendants included various former officers of Enron, its accountants, Arthur Andersen, and two law firms.

These defendant banks set up false investments in clandestinely-controlled Enron partnerships, used offshore companies to disguise loans and facilitated the phony sale of phantom Enron assets. As a result, Enron executives were able to deceive investors by reporting increased cash flow from operations and by moving billions of dollars of debt off their balance sheets, thereby artificially inflating securities prices. Unlike Lehman Brothers, Bank of America and the settling directors, the remaining bank defendants are potentially liable for Enron investors’ entire loss.

In February 2002, the University of California was named lead plaintiff in the Enron shareholders’ class action suit previously filed against 29 top executives of Enron Corp. and its accounting firm, Arthur Andersen LLP. UC filed a consolidated complaint on April 8, 2002, adding nine banks and two law firms as defendants in the case. In April 2003, US District Court Judge Melinda Harmon completed her rulings on the various defendants’ motions to dismiss and lifted the stay on discovery. Following those rulings, UC filed a second amended complaint on May 14, 2003.

Other institutional investors acting as representative plaintiffs on behalf of Enron investors include Washington State Investment Board, the UNITE Family of Funds, San Francisco City and County Employees’ Retirement System, Employer-Teamsters Local Nos. 175 & 505 Pension Trust Fund, Hawaii Laborers Pension Plan, Greenville Plumbers Pension Plan, Archdiocese of Milwaukee and Staro Asset Management.

The Post-WWI Republican Decade of Harding, Coolidge and Hoover

After eight years of Woodrow Wilson as Democrat president, for the following twelve years from 1921 to 1933, three Republican presidents, Warren G. Harding, Calvin Coolidge and Herbert Hoover, administered national policy with a conviction that the primary function of government was to assist big business in making maximum profit, rather than to police unsavory predatory corporate practices for the protection of small entrepreneurs and the consumer public.  The phony prosperity of the Roaring Twenties provided temporary but false validation of the conjured correctness of such convictions. Indeed, corporate profit soared to enable new investment in industrial expansion, increasing productivity and the national wealth. But much of the prosperity benefited only the financial elite, albeit some did trickle down to wage earners in the form of higher employment, low-cost consumer goods and a generally rising standard of living.

Regressive Impact of Excessive Corporate Profit

Although a significant portion of the population was still trapped in poverty, neither conservatives nor liberals in the 1920s were astute enough to realize that while the policy of stimulating maximum corporate profit might have been valid in the age of Alexander Hamilton when the US was a weak emerging economy plague with underdevelopment due to capital scarcity, and even after the Civil War when the US economy was transitioning from agrarianism to industrialism, such policy of condoning the mal-distribution of wealth in the name of the need for capital formation would inevitably lead to structural implosion in the new era of abundance and overcapacity. Public spending in education, health and social safety fell behind investment in the private sector.  Regional development was non-existent in government policy, leaving vast regions of the country in dire poverty, forcing rural population to migrate to urban areas to create massive problems of unguided urbanization, resulting in urban slums and the deterioration of central business districts. A similar policy blunder of neglecting the public sector was made in the 1990s and 2000s under both Democratic and Republican administrations.

Speculative Bubbles as Solution to Insufficient Demand

To keep growing in an economy of overcapacity due to insufficient demands, expansion could come only from speculative bubble to speculative bubble fueled by debt. Policymakers in the 1920’s then embraced wholesale dismantle of regulation adopted during the Progressive Era to again let the foxes guard the chicken in the financial market and to turn to debt/speculation-driven growth, rather than relying on the fundamental, utilitarian option of increasing wage income to combat insufficient demand. Eventually, the debt bubble burst from income being too low to sustain inflated asset prices or to meet either debt service or to sustain needed consumption, leading to widespread bank failures and company insolvencies.

Economic Equity is a Utilitarian Necessity

Only then did it became apparent to the voting public that government abdication of its primary role of maintaining fair and equitable wealth distribution had been the key contributing factor behind the structural weakness of free market capitalism. Economic equity is a utilitarian necessity, not just a moral principle. Fundamentally, the structural weakness of income mal-distribution and disparity behind the 1929 crash also caused the credit crisis of 2007 when debt greatly outpaced the ability of income to service it.  The US, leading the rest of the world, became the victim of a top-heavy finance sector expanding at a faster pace than the real economy, with massive amount of fiat money going to the places where it was not needed, such as speculation, rather than to rising wages on which a balance between supply and demand critically depended.

Wealth Disparity Creates Supply/Demand Imbalance

The economy of the 1920’s was not all fluff. Significant growth of production resulted from new scientific discoveries and technological inventions, new sources of inexpensive power, and new commercial and financial techniques to advance market efficiency. By 1929, sixty-nine workers could produce the same amount produced by one hundred workers in 1920, pushing aggregate production up by 45%. In 1929, national income reached $82 billion, an increase of 31% after inflation from 1919, against a population increase of 11%. But wage income as a proportion of national income continued to decline. Production value of basic necessities, such as food and clothing dropped from 58% of the economy to 43%, with sharp increases in new buildings and machinery and in durable goods such as autos, household appliances and telephones. Real wealth had been created in the 1920s; the only problem was that the wealth was not shared equitably, resulting in a supply/demand imbalance. And the imbalance was masked by an overblown prosperity created by debt and speculation. Workers were encouraged to speculate in the stock market with easy credit and low margin, pushing up share prices of companies whose profit strategy was to push down worker wages.

Similarity between 1920s and 1990s

Similarly, the economy of the 1990’s was highly innovative. Epoch making inventions and technical advances greatly increased productivity and vastly improved efficient use of resources. Communication made big leaps in speed, capacity, mobility and cost reduction. The digital revolution enabled exponential gains in information processing and data management, making the management of vast, complex systems over long distances routine. These advances required new regulations and standards to guide evolving systems toward paths of common good and away from paths destructive of sustainable growth. But while obsolete regulations were discarded, new relevant regulations were resisted for fear of hampering further creative innovation.

Within an unprecedented short time, the financial forces that commanded the rapid growth of profit from human intelligence managed to exploit deregulation to structure a socioeconomic regime that took on the appearance of natural law. Under neo-liberal ideology, the economy was encouraged to mimic the law of the jungle to favor the financially strong, rushing towards self destruction as the bottom of the food chain thinned out from over hunting and the top of food chain suffered from liver failure caused by an excessively rich diet. The problem was exacerbated by an unsustainable debt bubble and wild speculation.   Easy access to debt replaced even the need for capital, transforming capitalism into a debt-o-mania orgy.

In the 1920’s, the middle class for the better part of a whole decade was able to enjoy a standard of living previously only available to the very rich.  A new service sector of the economy emerged, giving rise to white collar workers as blue collar workers in manufacturing declining in proportion faster than in number.  By 1930, only 58% of the work force was engaged in production while between 1920 and 1929, industrial workers declined by 500,000 and farm workers declined by 250,000. Over 30% of the work force was engaged in the service sector, much of it devoted to serving speculative needs of the finance sector.

Henry Ford: Populist Industrialist

While the expansion of the late 19th century was centered on railroads, steel and oil, the expansion of the 1920’s was dominated by a building boom related to the manufacturing of automobiles. Henry Ford who formed the Ford Motor Company in 1901, was the first, and perhaps the only populist industrialist in US history. His Model T automobile, introduced in 1908, was produced with innovative assembly line technology to achieve a selling price for a quality product that was affordable by Ford workers, thus transforming the automobile from an expensive hand-made toy for the rich to a massed-produced utilitarian machine that transformed the transportation pattern of the nation and the world.  Ford also introduced the 40-hour week, giving workers leisure to enjoy outings with their families in his cars. Ford was able to carry out his populist idea of paying high wages to create buyers who could afford to buy the cars they built because he refused to surrender his control and independence to bankers and institutional investors who would insist on keeping wages at subsistence level to maximize corporate profit every quarter. Fordism spread to the entire manufacturing sector, producing household appliances, such as washer/driers, dishwashers, refrigerators, radios, etc at falling prices with rising wages that directly improved living standards. Fordism was one of the key factors in propelling the US into world power status.

General Motors and Du Pont

In 1904, William Capro “Billy” Durant at age 43 gained control of the Buick Motorcar Company which fell into financial difficulty selling luxury cars. Turning Buick into a successful mass production company of upscale vehicles for a mass market, Durant use the resultant profit to acquire other obsolete car producers and part suppliers such as Oldsmobile, Pontiac and Cadillac and others small companies in quick order into a giant corporation called General Motors (GM).

Overextended financially during the recession of 1910, GM was taken over by its bankers and control passed from Durant through a voting trust for five years.  Durant then went on to establish Chevrolet in September, 1915 to produce a car that would compete in price and volume with the Ford Model T, but offering more sale-inducing amenities such as a choice of colors against the black Model T.

When the bankers’ voting trust expired, Durant regained control of GM with financial support from the E.I. Du Pont family which had made a fortune with its exclusive pattern on dynamite production during World War I. War production continued to be highly profitable nonstop since.

In the spring of 1934, five and a half years before the beginning of World War II when Germany invaded Poland in September 1939, Fortune magazine ran an article entitled “Arms and Man”, a cheap expose unworthy of its lofty title. Among other things, it claimed that while it cost the War Department $25,000 to kill an enemy soldier, Chicago gangsters were doing it for $100 a head. Senator Gerald Nye (Republican, North Dakota), chairman of a special committee to investigate illegal links between business and armament, entered the article into the Congressional Records, remarking that “there has not been published in ages anything so enlightening.” The Nye investigation exposed a few well-known “surprises” about the international arms trade: that bribery occurred in Latin America and Asia - without linking the observation to the fact that most arms purchasers at the time were located in those two turbulent regions, that home governments were enlisted to secure foreign sales, that arms manufacturers always sold to any customer paying cash or with good credit regardless of morals or politics, and often to both sides of the same conflict, and that arms embargoes were universally opposed by the arms industry as ineffective and only resulting in smuggling.

The Nye investigation did reveal that Du Pont’s plant near Nashville had grossed a profit of 40,000 percent on its capital, soliciting a response from Pierre DuPont that since his company was selling explosive technology rather than a commodity (gunpowder) to the government, looking at return on capital was misleading. Microsoft uses essentially the same rationalization on spectacular profits derived from intellectual property a century later, as does the drug industry.

With predatory acquisition and financial manipulation, GM overnight became the biggest automaker in the world and the most spectacular moneymaker of the 1920’s. GM was in the business of making money and the fact that it did so through auto manufacturing was only incidental. Ford’s paternalistic management style was no match for the organizational approach of GM. Anyone who invested $25,000 in GM in 1921 was a millionaire by 1929.  Durant became one of the richest men in the country. By 1928, 24.5 million cars had been produced, employing 4 million workers, about 10% of the work force, while Federal and state governments spent over $1 billion a year to build roads for them, with the effect of greatly increasing land value in the new “suburban” bedroom towns.

Other industries also experienced unprecedented growth, the most spectacular being the rapid increase in electricity production, which increased from 7.5 billion horsepower to 44 billion, a 600 per cent increase from 1912 to 1930 (1 hp. = 2,545. 6 BTU per hour). Aviation was another technological triumph. The Wright brothers made their first flight in December 1903 and Charles Lindbergh flew the Spirit of St Louis in a historic first cross-Atlantic flight from NY to Paris in 1927. The age of coal and steam was being replaced by the age of oil and electricity which historians labeled the Second Industrial Revolution. A wave of unimpeded optimism swept the whole nation.

Free Market Failed to Distribute Income Fairly

Unfortunately, a serious weakness in the economic system was the inability of the free market to distribute income fairly to sustain consumption needed for absorbing the increased production. With each passing decade since the Civil War, corporatism had achieved increased dominance in the US economy and a greater share of its new wealth. In 1929, out of 460,000 corporations, 1,350 had annual income in excess of $1 million, earning 80% of all corporate profits. Half of the corporate wealth and 25% of the national wealth were concentrated in 200 firms. Gigantism was in full bloom under a general rule of grow or die. Many did die so that a few might become giants who kept most of the wealth for their shareholders.

Though wages did rise enough to check the growth of unionism, wages rose at half the rate of productivity all though the 1920’s.  Wages in the decade rose 33%, management salary rose 42%, corporate profit rose 76% and stockholder dividend rose 108%. Pension funds were not significant investors until after the New Deal strengthened worker pensions, thus dividend income in the 1920s went mostly to the rich. Wage earners were receiving a smaller share of national income. Half of the farming families had annual income below $1,000, less than $3 a day, less than what low wage workers in Asia receive today under globalization.

Too much money was going to the rich elite who invested their savings in more productive capacity and too little money was going to wage earners whose spending was needed to balance supply with demand. Overcapacity then was handled with sharp rise in consumer debt and by encouraging speculative gains on all levels. But debt addiction required more debt until the debt bubble rose beyond the ability of income to carry. When the speculation bubble burst, the excessive outstanding debt faced default through the decline of the market value of the collaterals. The broad interconnection of debt obligations caused a systemic collapse and the Great Depression began. Fundamentally, the debt crisis of 2007 had similar causes.

GM shares fell sharply as the stock market began to stall in April 1929. Durant could have stood on the sideline to wait for the recovery. Instead, he was forced by high leverage to try to protect his investors and employees by attempting in vain to support GM share prices, buying in the open market with full use of margins with limited backing from the Rockefeller interests. By October, GM share price had fallen by two-thirds of its previous April price of $42 to $14, a fraction of its peak price of $210 in 1926. On November 16, Durant barely managed to meet a new margin call for another $150,000 when the Rockefellers cut off further support.  Two days later, when the GM share price fell by another 50 cents, Durant failed to meet a new margin call and lost control of his 3 million shares of GM stock to JP Morgan and the Du Ponts. Unlike top executives of failed firms in 2008 who left in disgrace and still managed to leave with tens of million of dollars of company money in severance pay, in 1929, one of the world’s ten richest men went bankrupt at age 68 and spent the rest of his days with a small stipend from GM, managing a bowling alley in Flint, Michigan for another 18 years until he died at age 86 in 1947.  Those who insist that 2008 is not like 1929 have a point. The other difference is that in 1929, the loss was not borne by pension funds which were largely created by the New Deal, unlike 2008 when pension funds have lost untold billions on supposedly no-risk AAA-rated investments.

Cutting Production to Maintain Prices

Instead of cutting prices to maintain production, the financial establishment in the 1930’s opted for maintaining prices through price fixing by cutting production volume, which caused fixed cost per unit to increase and unemployment to rise and aggregate wage income to fall further in a downward spiral. Another cause of the 1930’s depression was the economy’s excessive dependence on the sale of luxury and capital goods, rather than on basic necessities. In bad times, such discretionary luxury sales dropped precipitously and caused the economy to stall. These conditions are similar to those in 2008.

A Matter of Confidence

Material economic factors were not the only causes for the Great Depression. The speculative frenzy had pushed the economy into overdrive and the bursting of the speculative bubble left investors with more than just losses. It wiped out all optimism as well as savings. Confidence in the market and the economic system vanished in a matter of days and capitalism was left without its key source of energy. Loss of confidence is the major cause of a liquidity trap, a situation in which preference for cash overrides all other market decisions.

Friedman’s Counterfactual Conclusion

Milton Friedman in his study of the 1929 crash and the subsequent depression (Monetary History of the United States, 1963) concluded that if only the Fed had provided adequate liquidity, the stock market crash would have recovered to avoid the depression. Friedman concentrated his focus on the curative effect of monetary policy on recessions and did not have much to say about the preventive role of monetary policy on debt bubbles except that inflation is a monetary phenomenon. Friedman did not have much to say about debt and bubbles.

Friedman accepted the technical definition of inflation as measured, if not caused, by rising wages. He held out hope that a monetary policy focused exclusively on price stability could moderate if not eliminate the business cycle, at least moderate the severity of the bursting of a debt-pushed economic bubble without hampering the boom. His monetarist dogma gave support to the flawed central bank doctrine of measuring inflation by the rate of increase of wages and consumer prices while detaching inflation from asset price increases which central banks welcomed as desirable “wealth effect”, which permitted the debt bubble and masked the problem of earned income deficiency for servicing the outstanding debt.

Friedman’s counterfactual claim of a liquidity magic-wand solution for the Great Depression was merely academic speculation since in 1929 the Fed could not legally print money without increasing its gold holdings, set at $30 per ounce by the Gold Standard Act of 1900. The act specified that the dollar should consist of twenty-five and eight-tenths grains of gold nine-tenths fine, as established by Section 3511 of the Revised Statutes of the United States, shall be the standard unit of value, and all forms of money issued or coined by the United States shall be maintained at a parity of value with this standard, and it shall be the duty of the Secretary of the Treasury to maintain such parity. Friedman was advocating the abandonment of the Gold Standard, a position long held by populists.

Greenspan Applied the Friedman Solution to Save the Market from the 1987 Crash

The 1987 market crash on Black Monday, October 19 when the Dow Jones Industrial Average fell 22.9% in one day from the effects of portfolio insurance and program trading, was more severe than on Black Monday, October 28, 1929 when the DJIA dropped 11.7%. Black Monday 1987 saw the largest one-day decline since 1914. Greenspan, newly appointed by President Reagan as chairman of the Fed in 1987, bought Friedman’s liquidity fallacy wholesale. He issued a one-sentence statement at 8:41 a.m. on Tuesday, Oct. 20, 49 minutes before the markets opened at 9:30 a.m.:
"The Federal Reserve, consistent with its responsibilities as the nation’s central bank, affirmed today its readiness to serve as a source of liquidity to support the economic and financial system."
Greenspan, free from the gold standard that constrained the Fed in 1929, proceeded to use the Fed’s now unlimited power to create fiat money to offset the losses in the 1987 crash to keep the market from seizure, with E. Gerald Corrigan, president of the New York Federal Reserve Bank, which normal transaction of over $1 trillion in the money market each day, strong-arming all the major banks not to withhold payments for fear of counterparty default.  This posture of the Fed saved the market but started a dangerous trend of moral hazard in subsequent economic slowdowns. The Fed has since provided endless liquidity to finance consecutive debt bubbles and their subsequent collapses: 1987 (23% drop, recovered in 9 months), 1998 (36% drop, recovered in 3 months) and 2002 (37% drop, recovered in 2 months), each time leading to a bigger debt bubble. After 18 years of debasing the dollar with excess liquidity, the Greenspan approach ultimately landed the debt-infested global economy in its current disastrous state of collapsing asset prices denominating in rapidly depreciating money, causing a financial meltdown that additional liquidity of increasingly worthless money can no longer hold up. Worse yet, spiraling prices in food and energy, exempted by the Fed from its core inflation index, while wage income has remained stagnant, are creating social and political instability around the world. 

Bernanke Continues the Friedman/Greenspan Liquidity Fallacy to Deal with Insolvency

The Bernanke Fed has adopted the Freidman/Greenspan liquidity fallacy and has been desperately trying to provide more liquidity to try to regenerate a finance sector stalled by the August 2007 credit market seizure. Yet many companies outside of the financial sector, at least those that have not yet been acquired by private equity firms with leveraged debt, are flooded with cash of declining purchasing power but cannot find profitable investments for it, mostly because falling prices of assets are still too high relative to declining earnings from weak market demand. Private equity firms were acquiring companies at high valuation with massive debt. Financial institutions are now desperately trying to raise additional capital to meet write downs from mounting losses.

Wachovia, the fourth-largest US bank by assets, warned on April 14, 2008 that the US economy was deteriorating more rapidly than expected as it revealed plans to raise $7 billion in additional capital with the sale of common stock and convertible preferred shares, a discount of more than 15% to Wachovia’s share price on the previous Friday closing, after announcing a first-quarter loss of $393 million.  It will cut dividend by 41%, providing an additional $4 billion of capital in two years, and shed 500 jobs in its investment bank.  Wachovia acquired major California adjustable rate mortgage lender Golden West Financial for $26 billion at the height of the housing boom, a purchase widely derided at the time as too expensive and riddled with risk.

Washington Mutual, the largest US savings and loan group, said a week earlier it would raise $7 billion in additional capital. Many more US banks are expected to raise additional capital in the coming months to shore up balance sheets weighed down by rising defaults on mortgages, credit cards, auto and other big-ticket item consumer loans. What the need for additional capital means is that more liquidity is not a solution for insolvency.

Keynes on Liquidity Trap 

As Keynes observed, no amount of liquidity can overcome a liquidity trap. In that situation, injecting more liquidity into a stalled market serves no purpose except to cause more inflation without halting economic slowdown. The problem in 1929 was, as it is in 2008, that asset prices buoyant by speculation had outstripped the purchasing power of stagnant income of consumers. Assets and commodities in the economy were valued at price levels that aggregate wage income could not sustain. The solution was not to inject more useless liquidity to sustain inoperative price levels which will only make the problem worse, but to introduce demand management through full employment and to let wages quickly rise back up to the level of wage-price equilibrium.  This was the policy objective of Roosevelt’s New Deal Program, an objective not yet recognized by policymakers in 2008 even amid a revival of populist rhetoric.

Denials in 1929 and 2007

During the summer before the stock market crash in October 1929, symptoms of the economy stalling were surfacing with layoffs in construction, steel, the auto sector and capital goods manufacturing. Official reaction was adamant denial in 1929, as it was in 2007, pointing to the booming financial sector as evidence of a new economy of endless growth, assuring the public with empty talks of good fundamentals in the economy and that the economy was merely going through growing pains, wringing out inefficiencies to move on to new heights.

Unfazed unemployed workers spent their idle days at retail brokerage houses making more money trading stocks than their working wages ever brought home, expecting to be part of a new nation of speculative millionaires who no longer needed to do productive work. They used as capital the appreciated equity in the homes, the only substantial asset they owned, albeit did not earn, and speculate on high margin eagerly provided by their brokers, fighting each other to plunge into an overheated market that pundits kept telling them would go still much higher.

Banks Promoted Speculation

For example, in the 1920s, the National City Bank under Charles H. Mitchell, the forerunner of CitiGroup today, along with its competitors, did everything possible to encourage stock trading by as many common folks as possible, providing credit to anyone willing to sign for a loan collateralized by the shares he intended to buy. The loan was based on the value of the collateral, not the creditworthiness of the borrower. It fact, the less creditworthy borrowers were charged higher interest rates against “safe” collaterals of rising share prices, making them preferred customer for the banks.

In the 2000s, subrpime status was a credit score for charging higher interest rates, not a factor to deny credit because the mortgage was collateralized by houses of rising market price. The mortgages were then securitized into tranches of varying credit rating and sold to investors with varying risk appetite. In 1929 as in 2007, as prices turned against these highly leveraged buyers with insufficient cash flow, their brokers were forced to sell their holdings as borrowers failed to meet margin calls, not unlike what Bear Stearns & Company was faced with in one weekend in late March 2008, except that the Fed in 1929 did not come to the rescue of the small speculators who, unlike Bear Stearns, were deemed dispensable because they individually were not “too big to fail”. The irony was that, as a group, individual small speculators in 1929 were as big if not bigger than Bear Stearns’ dispersed counterparty network, or that of any other single broker-dealer even today. The cumulative effect of default by large number of small speculators brought down the entire market.

Economic Crisis Dominated Politics

The economic crisis of the 1930s that followed the 1929 crash dominated US politics for a whole decade until the onset of World War II. Both Republican President Herbert Hoover and later Democrat President Franklin D. Roosevelt attempted to bring about recovery within the context of their separate ideologies. Government encouragement of, and assistance to economic growth had been the established practice of the US since the time of Alexander Hamilton. However, under Roosevelt, the measures adopted by the New Deal were unprecedented in scope and involved far-reaching change in the relationship between government and big business, and more importantly, on behalf of the common man. It was a politics of Populism.

Hoover and the Corporate State

Hoover was apprehensive of the growing power of the state to threaten the spirit of private enterprise which, if unchecked, would eventually produce a “super state where every man becomes the servant of the State and real liberty is lost.” He was oblivious to the danger of the corporate state in which the freedom of the common man is threatened. As a Quaker, Hoover believed that relief for the unemployed and other individual victims of disasters should be left to voluntary private charity funded by those more fortunate. In Hoover’s world, the more fortunate tended to be those favored by government policies. On the other hand, if needy individuals fell into the habit of dependence on government assistance, liberty and the enterprising spirit will be undermined.

The White House biography on Hoover reads: After the Armistice, Hoover, a member of the Supreme Economic Council and head of the American Relief Administration, organized shipments of food for starving millions in central Europe. He extended aid to famine-stricken Soviet Russia in 1921. When a critic inquired if he was not thus helping Bolshevism, Hoover retorted, “Twenty million people are starving. Whatever their politics, they shall be fed!”

It was a far cry from the US foreign policy of trade and economic sanction after WWII against nations deemed undemocratic.

On the other hand, Hoover felt that the Federal government might legitimately give financial and regulatory assistance to big business to preserve private enterprise for the common good, because he saw private profit as the sole source of wealth on which the government as well as private charity depended for funds. It was an approach of feeding the horse that pulls the carriage. Yet as economist John K. Galbraith famously quipped about trickling down prosperity: If you feed the horse enough oats, the sparrows will eventually benefit from its droppings.

Hoover held strong personal conviction and showed considerable strength in standing by his belief through the initial months of the depression that began in late 1929.  Yet his willingness to give Federal aid to big business while denying public assistance to starving families caused him to appear heartless and contrary to the American good Samaritan tradition.

Hoover was a man of high personal integrity, an efficient administrator and extremely hard-working, but his elitist approach put him in history as a president who took office under favorable auspices and left more distrusted and disliked except Andrew Jackson immediately after the Civil War and perhaps George Bush in 2008. Ironically, he was urged to ran for the highest office as a Democrat in 1911 by none other than a young and rising Franklin D. Roosevelt, but Hoover declined, commenting that he could not ran for a party whose only member in his boyhood home had been the town drunk.

Yet during the first two years after the 1929 crash, Hoover doubled Federal spending on public works through private contractors, urged big business not to cut wages and sponsored expansionary monetary policies to extend credit to companies. Before the crash, Hoover called a special session of Congress in the summer of 1929 to deal with early signs of economic slowdown, which turned into a free for all for special interests demanding high tariffs against unfair foreign competition that sold goods and agricultural products to US consumers at prices below those charged by domestic producers.

Impact of Smooth-Hawley on Trade

After the 1929 crash, the Smoot-Hawley Tariff Act was passed by overwhelming majority in Congress and signed into law by Hoover despite a petition signed by over 1,000 economists warning against it.  Other governments immediately imposed countervailing tariffs and world trade came to a screeching halt. The value of US export fell from $5.2 billion in 1929 to $1.6 billion in 1932, the lowest in constant dollars since 1896. The stock market, having tracked the fortune of Smoot-Hawley in Congress, began a downward slide for two and a half years after the bill became law.

In 1929, the Federal Reserve, whose powerful chairman, Benjamin Strong, having recently died, was left without leadership and continued Strong’s long-established anti-inflation bias of an earlier era. Many observers in hindsight, including Milton Friedman, quoted Strong’s 1928 statement that “the very existence of the Federal Reserve System is a safeguard against anything like a calamity growing out of money rates. … We have the power to deal with such an emergency by flooding the Street with money.”  The counterfactual conclusion is that if the Fed had “flooded the Street with money”, the depression could have been avoided. This is a controversial point. It might be that flooding the Street with money would only create a bigger bubble that would burst later, as Greenspan and Bernanke would find out seven decades later.

Hoover Misread Dead Cat Bounce as Recovery

Hoover was not being purposely deceptive when he announced that “prosperity is just around the corner,” as he truly believed that with a revival of confidence, recovery would be at hand. The year 1929 ended with what is now known as a “dead cat bounce” which was widely mistaken for a recovery. The market rebound continued until the Spring of 1930 despite a continuing decline in economic activities. When a group of concerned clergy went to Hoover to urge a public works program to help the unemployed, the confident president told them that they had “come six months too late; the depression is over.”  Having fallen almost 20% from its all time high of 14,164 in October 2007 to 11,740 in March 10, 2008, the DJIA has since surged almost 11% from its low in two months. It shows all the signs of another dead cat bounce.

By the summer of 1931, as the economic depression spread around the world, Hoover persuaded the victorious WWI allies to accept a one-year moratorium on all war debts and reparation payments which never resumed with the election of Adolf Hitler in Germany. Right wing populism infested German politics and paved the way for the rise of Nazism. At home, Hoover proposed a comprehensive program of aid for home owners threatened with foreclosures and bankruptcy, putting emphasis on the needs of the economy rather than the needs of individual families, arguing that neighborhood blight could result from vacant houses, somewhat similar to the range of programs proposed in 2008.

The Democrats gained control of Congress in the 1930 midterm election from a resurgence of farm-belt progressivism. Yet the new Congress did not respond quickly to the Hoover proposed programs. The Democrats wanted more appropriation for direct relief to distressed individuals rather than through subsidies to distressed corporations. After long and bitter debate and confrontation with the Hoover White House, the Democratic Congress created a Reconstruction Finance Corporation to lend funds to needy corporations. Home-owners threatened with foreclosure could have their mortgages refinanced by one of the twelve newly created Federal Home Loan Banks while farmers could receive help from the new Federal Land Banks.

Six decade later, the Financial Institutions Reform, Recovery and Enforcement Act of 1989 (FIRREA) enacted in the wake of the Savings and Loan crisis of the 1980s and signed into law in August 1989 by Republican President George HW Bush established the Resolution Trust Corporation (RTC) to close hundreds of insolvent thrifts and provided funds for pay out insurance to their depositors.

The Savings and Loan Crisis of 1980

Since early 19th century, Savings and Loan institutions have existed to finance homeownership though the pooling of community funds. They were tightly regulated with ceilings on the interest rates they were allowed to offer to depositors and the limitation on funding residential mortgages only within their homicide. High inflation in the 1970’s and deregulation of money markets mandated by Depository Institutions Deregulation and Monetary Control Act of 1980 (DIDMCA) signed into law by Democratic President Carter removed the power of the Federal Reserve Board of Governors under the Glass-Steagall Act and Regulation Q to set the interest rates of savings accounts and caused significant outflows of low-rate deposits from S&Ls, as depositors moved their money to the new high-yield money-market funds. With funds locked up in long-term (30-year mortgages written years earlier at fixed interest rates - variable rates mortgages were illegal until 1981) that were worth less than face value in a high interest rate environment, many S&L’s were threatened with insolvency in a regime of term mismatch of interest rates between deposits and loans.

The situation was further exacerbated for the Savings and Loan institutions by Regulation Q which regulated the interest rates that savings and loans and banks were allowed to offer on their savings accounts. Interest rates were capped at 5.25% for banks and 5.5% for Savings and Loans. While S&Ls were offering 5.5% to their depositors, US Treasury bills were yielding over 8% in 1970 and over 15% around 1980. Between 1978 and 1981 money market mutual funds grew from $9.5 billion to $188.6 billion in assets, and many of their customers came from banks and S&Ls.

Policymakers focused on the symptoms of the sick S&L industry in 1979 and 1980. To address the problems created by a portfolio full of long-term, fixed-rate assets, Congress and the administration sought to offer S&Ls additional investment opportunities. Thus, adjustable rate mortgages were finally allowed to track market rates and to transfer interest rate risk from the lenders to borrowers.

The 1980 DIDMCA signed by Democrat president Carter and the Gain-St Germain Depository Institutions Act of 1982 signed by Republican president Reagan also expanded acceptable S&L investments by permitting them to make short-term consumer loans, issue credit cards, and commercial real estate loans nationwide outside of their home communities. Policymakers hoped that broader powers would allow S&Ls to better diversify their portfolios so that they could increase their short-term earnings and be less vulnerable to future interest rate volatility and economic instability. Policymakers also addressed S&Ls' funding problems. The 1980 DIDMCA initiated a six-year phase out of deposit interest rate ceilings and encouraged the development of new, longer-term savings instruments.

In a last-minute conference committee compromise, Congress also expanded federal deposit insurance coverage from $40,000 per account to $100,000 per account, greatly increasing the government’s liability. In addition to raising the amounts covered by insurance, the amount of the accounts that would be repaid was increased from 70% to 100%. Increased coverage by Federal Savings and Loan Insurance Corporation (FSLIC), also permitted managers to take more risk to try to work their way out of insolvency so the government would not have to take over an institution.  FSLIC was created as part of the National Housing Act of 1934 in order to insure deposits in S&Ls, a year after the FDIC was created to insure deposits in commercial banks. It was administered by the Federal Home Loan Bank Board (FHLBB).

In the 1980s, during the Savings and Loan Crisis, the FSLIC became insolvent. Outstanding US mortgage loans grew from $700 billion in 1976 to $1.2 trillion in 1980. FSLIC was recapitalized with taxpayer money several times, including with $15 billion in 1986 and $10.75 billion in 1987. However, by 1989 it was deemed too insolvent to save and was abolished along with the FHLBB by the FIRREA; savings and loan deposit insurance responsibility was transferred to the FDIC

One of the most important contributors to the S&L crisis was deposit brokerage in which brokers were paid a commission by the customer to find the highest yield certificate of deposit (CD) issued by a S&L anywhere in the nation. These CDs are usually risk-free short-term $100,000 CDs fully guaranteed by FSLIC. With the lifting of the previous 5% limit of brokered deposits, any small single branch thrift could attract a large number of deposits simply by offering the highest rate. In order to make money off this expensive money, it had to lend at even higher rates to riskier investments.

This system was made even more damaging when some deposit brokers instituted a scam known as “linked financing” in which a deposit broker would approach a thrift institution with the offer of steering a large amount of deposits to that thrift on condition that the thrift would lend to specified borrowers. Some of these borrowers were real estate developers who agreed to pay a fee to the broker for securing the loan. Other borrowers were paid by the broker to apply for loans that they agree to turn over to the deposit broker and subsequently defaulted. Michael Milken of Drexel, Burnham and Lambert packaged brokered funds for deposit in several large S&Ls on the condition that the institutions would buy high-yield junk bonds of his clients. Drexel went bankrupt and Milken went to prison as part of the fallout of the S&L crisis.

Hoover Promoted Home Ownership

In 1921, Hoover, as Commerce Secretary under President Harding, launched the “Own Your Own Home” campaign to promote ownership of single-family dwellings, including the Better Houses in America movement, the Architects’ Small House Service Bureau, and the Home Modernizing Bureau. He worked with bankers and the savings and loan industry to promote the new long term home mortgage, which dramatically stimulated home construction.

As president, Hoover urged the Federal Reserve to liberalize extension of credit to banks to allow them to lend to bank customers. The major error Hoover made was a tax increase to keep the budget balanced, instead of using deficit financing as Roosevelt did two years later. The Hoover recovery program did not have a chance to take effect as by the time they came into operation the 1932 presidential election was approaching. Republicans since Hoover have repeatedly looked to tax cuts as the preferred path to stimulate the economy and to cut Federal spending to balance the Federal budget. The problem with that approach is that tax cuts tend to favor the rich who pay more taxes and cuts in Federal spending tend to penalize the poor who depend more on government services. It further exacerbates the distribution imbalance of wealth that results in insufficient demand.

The 1932 Presidential Election

During the 1932 campaign, Hoover, running as an incumbent against Roosevelt, defended his recovery program as beginning to show results and that the severe depression was caused by global conditions over which the US had no direct control.  The Democrats also ran on a platform of promising a balanced budget, a cut in Federal expenditure, a sound currency and no government interference in the private sector. Roosevelt even accused Hoover of failing to keep the budget balanced. But voters were looking for a change in leadership even though both parties were promising very similar solutions to the economic crisis.

The economy took a drastic turn for the worse right after the 1932 election, as effective leadership was largely absent during the political campaign. By February 1933, panicked depositors were withdrawing money from banks at such an alarming rate that state governments were compelled to intervene. Michigan declared a bank “holiday” in the state on February 14 and by the time Roosevelt took office on March 4, every other state in the union had taken similar action. GNP fell a record 13.4%; unemployment rose to 13 million or 23.6%.


Before being elected president, few observers expected Roosevelt to be the outstanding leader he actually turned out to be. Though fully devoted to the American ideal of popular democracy with an innate sympathy for the underdog and distaste for the privileged and for exploitation and injustice, Roosevelt entered the White House with no fixed ideological doctrine but with a high degree of Yankee pragmatism.

In fighting to achieve his political objectives of social justice, Roosevelt showed stubborn courage and consummate political skill. Above all he was unequal in intuitive grasp of popular sentiment and unmatched in capacity for giving it political expression and policy direction. His radio speeches, given as “fireside chats” in simple language that common folks could understand, enabled him to reach more people than any previous leader. This common touch from a Brahman background along with his trademarked Rooseveltian gusto and self-assurance made him a folk hero.

His supporters both during his lifetime and in history consider him the greatest of US presidents.  His detractors, on the other hand, accused him of too incline to concentrate authority, of capacious administration that led to duplication, confusion and waste, and most significantly of dictatorial tendencies, notwithstanding the fact that Roosevelt was a leader in times of crisis and war.  

Next: the Birth of the New Deal