Global Post-Crisis Economic Outlook
Henry C.K. Liu

Part I:    Crisis of Wealth Destruction   
Part II:  Two Different Banking Crises - 1929 and 2007
Part III: The Fed’s No-Exit Strategy
Part IV: The Fed’s Extraordinary Section 13(3) Programs
Part V:  Public Debt, Fiscal Deficit and Sovereign Insolvency
Part VI: Public Debt and Other Issues

This article appeared in AToL on  May 2, 2010 as: Public Debt - Prudence and Folly
Recently much noise has been made by fiscal hawks about the danger of high fiscal deficits and national debts. Yet the purported danger comes not from the size of the deficits or debt, but on how the proceeds from them are used. In recent decades, the US economy has suffered from such proceeds being spent on programs that were not conducive to sustainable economic growth or constructive to economic health.
During the course of World War I, US national debt multiplied 27 times to finance the nation’s participation in war, from $1 billion to $27 billion. The US military drafted 4 million men and sent over a million soldiers to France, solving the domestic unemployment problem overnight plus putting women into factories and creating a sharp rise in aggregate demand as troops had to be supported at a level of consumption exponentially higher than civilians could through market forces in peacetime. War was a blessing to the US economy as military demand put US industries humming at full capacity while the homeland was exempted from war damage.
Far from ruining the US economy, war production financed by public debt catapulted the country into the front ranks of the world’s leading economic and financial powers, because the US homeland was not affected by war damage and civilian consumption was curbed in the name of patriotism. The national debt turned out to be a blessing, because a good supply of government securities provided for a vibrant credit market and public sector spending created the rise in demand that private companies could satisfy profitably with a guaranteed market.
The truth is that the positive economic functionality of the national debt rests not so much on its level, high or low, but on how the debt is expended. When the national debt is use to expand economic production with full employment and rising wages, it will produce positive economic effects. But if the national debt is used to finance speculative profits achieved through pushing down wages via cross-border wage arbitrage, or to structure ballooning interest payments to service old debts by assuming more new debts, it will eventually drag the economy to a grinding halt by a crisis of debt implosion.
World War I raised the federal debt to $27 billion, about 34.5% of GDP to produce a vibrant productive economy of full employment. In March 2009, the Congressional Budget Office (CBO) estimated that US gross debt will rise from 70.2% of GDP in 2008 to 101% in 2012, while the economy is expected to stay in open-ended recession with unacceptably high unemployment at over 10%. The difference is that in 1919 the federal debt was used to finance war production while in 2012 the public debt is expended to refinance the speculative debt bubble.
Less that a decade after the war, by 1928, US gross debt fell to $18.5 billion, but the money so released was absorbed mostly by speculative profit to cause the market crash in 1929. In 1930, a year after the crash, US gross debt fell further to $16.2 billion under President Hoover’s balance budget and the Fed’s tight money policy under Chairman Roy Archibald Young.
During Young’s term in office as Chairman of the Fed there was confrontation between the Federal Reserve Board and the Federal Reserve Bank of New York under George L. Harrison of how to curb speculation that lead, inter alia, to the stock market boom of the late 1920s. The Board was in favor of putting “direct pressure” on the lending member banks while the Federal Reserve Bank of New York wanted to raise the discount rate. The Board under Young disapproved this step, however Young himself was not fully convinced that the policy of using pressure would work and refused to sign the 1929 Annual Report of the Board because it contained parts favorable to this policy.
Eugene Isaac Meyer was appointed by Herbert Hoover to be Chairman of the Fed on September 16, 1930. Meyer strongly supported government relief measures to counter the effects of the Great Depression, taking on an additional post as chief of the Reconstruction Finance Corporation (RFC), modeled after the War Finance Corporation of World War I.
The RFC gave $2 billion in aid to state and local governments and made loans to banks, railroads, farm mortgage associations, and other businesses. The loans were nearly all repaid after the Depression. RFC was continued by the New Deal and played a major role in containing the Great Depression and setting up the relief programs that were taken over by the New Deal in 1933. 
Upon Franklin D. Roosevelt’s inauguration in 1933, Meyer resigned his government posts. Months later, he bought the Washington Post at a bankrupt auction and turned it into a respected and profitable newspaper. His daughter, Katherine Graham, was publisher of the Washington Post when it exposed the Watergate scandal that led to the resignation of President Richard Nixon on August 9, 1974.  Meyer was appointed by President Truman after WWII to be the first president of the newly formed World Bank.
After the launching of the New Deal in 1933, US gross debt rose to $62.4 billion, at 52.4% of GDP. By 1950, WWII had pushed US gross debt five folds to $356.8 billion but only at 94% of GDP. After 1950, US gross debt fell steadily as a percentage of GDP to a low of 33%, with a nominal value of $909 billion in 1980 under President Jimmy Carter. Since then, US gross debt had not fallen below 56% of GDP. Projected US gross debt for 2011 is $15.7 trillion at 101% of GDP. Much of the debt money in the two years since the credit crisis has ended up in the wrong pockets of distressed financial firm but not the needy public, depriving the US economy of full employment with rising wages to increase aggregate demand.
While US public debt in 1946 reached $300 billion, at 135% of GDP, the post-war years were prosperous years for the US. These data show clearly that it is not the level of the public debt, but how the debt money is spent that determines its impact on the economy.

The Issue of Fiscal Deficit

Sometimes a large fiscal deficit can help actually reduce its share of the GDP if the fiscal deficit generates a bigger GDP.

The Federal fiscal deficit in 1919 was 16.8% of a GDP of $78.3 billion. Between 1920 and 1929, the Federal budget had a small surplus, while the GDP grew to $103.6 billion in 1929. After the 1929 crash, the 1930 GDP fell $12.4 billion, about 12%, to $91.2 billion, while the Federal budget under Hoover still had a surplus of 1% of GDP.
Not until Franklin D Roosevelt came into office in 1933 when the GDP had fallen by almost half to $56.4 billion that the Federal deficit jump to 3.27% of GDP in 1934. All through the New Deal years, the Federal fiscal deficit stayed below 5% with the average annual deficit at around 3% of GDP and did not rise until after the USentered WWII and peaked at 28.1% in 1943, 22.4% in 1944 and 24.1% in 1945 but falling to 9.1% in 1946 when the GDP was $222.2 billion. once of the reasons that the New Deal had not been as effective as could be was due to Treasury Secretary Henry Morganthau's warning to FDR to  reduce Federal spending to avoid a large fiscal deficit.

The war time Federal deficit in 1945 was 24.1% of a GDP of $223 billion. Despite a high fiscal deficit, US GDP kept rising after the WWII to $275.2 billion in 1948 with a fiscal surplus equaling 4.3% of GDP. The 2010 Federal deficit is project to be 10.6% of a GDP of $14.6 trillion.  
The total Federal fiscal deficit for the four years of WWII was about 100% of the average annual GDP of the same period. At the same time, the US grew to be the strongest economy of the world because the fiscal deficit was used to finance war production, not to bail out distressed financial institutions and inefficient industrial firms.
US fiscal deficit for FY2009 was more than $1.75 trillion -- about 12.3% of GDP, the biggest since 1945. According the White House Budget Office, the cumulative fiscal deficit between FY2009 and FY2019 is projected to be almost $7 trillion.  Total gross Federal debt in 2008 was $10 trillion, projected to rise to over $23 trillion in 2019. Debt held by the public is projected to rise from $5.8 trillion in 2008 to $15.4 trillion in 2019. Interest expense in 2008 was $383 billion. Projection is expected to rise as both debt principal and interest rate are expected to rise. But what the WHBO did not mentioned was how big the GDP  would be if the fiscal deficits were to be spent to stimulate constructive developments.
The Issue of Inflation
Inflation is a different story. Moderate inflation is necessary for optimum economic growth, provided the burden of inflation is equally shared by all segments of the population, particularly wage earners. By the end of World War I, in 1919, US prices were rising at the rate of 15% annually, but the economy roared ahead as wages were rising in tandem with or slightly ahead of prices through wage-price control.
Income policies involving wage-price control were employed throughout history from ancient Egypt, Babylon under Hammurabi, ancient Greece, during the American and French revolutions, the Civil War, World War I and II. A case can be made that that wage-price control has a mixed record as a way to restrain inflation, but it is irrefutable that income policies are effective in balancing supply and demand.
Yet in response to inflation, the Federal Reserve Board raised the discount rate in quick succession in 1919, from 4% to 7%, and kept it there for 18 months to try to rein in inflation by making money more expensive when banks borrowed from the Fed. The result was that in 1921, 506 banks failed.
The current financial crisis started in late-2007 and stabilized around mid-2009 after direct massive Fed intervention. It was by many measures an unprecedented phase in the history of the US banking system. In addition to the systemic stress and the stress faced by the largest investment and commercial banks, 168 depository institutions failed from 2007 through 2009.  This was not the largest number of bank failure in one crisis. At the height of the savings and loan (S&L) crisis from 1987 to 1993, 1,858 banks and thrifts failed. However, the dollar value of failed banks assets in the financial crisis in 2007-2009 was $540 billion, roughly 1.5 times of the bank assets that failed in the S&L crisis in 1987-1993.     
A research paper funded by the Federal Deposit Insurance Corporation (FDIC) on Bank Failures and the Cost of Systemic Risk: Evidence from 1900-1930, by Paul Kupiec and Carlos Ramireza (July 2008) found that bank failures reduce subsequent economic growth. Over this period, a 0.12 percent (1 standard deviation) increase in the liabilities of the failed depository institutions results in a reduction of 17 percentage points in the growth rate of industrial production and a 4 percentage point decline in real Gross National Product (GNP) growth. The reductions occur within three quarters of the initial bank failure shock and can be interpreted as a measure of the costs of systemic risk in the banking sector. The FDIC had been created by the New Deal only after 1934 to protect depositors.
In the current crisis that began in mid-2007, with the discount rate falling steadily to 0.5% on December 16, 2008 from a high of 6.25% set on June 2006, still 25 banks failed in 2008 and were taken over by the FDIC while 140 banks failed in 2009 and 33 banks failed in just the first two months of 2010, putting the fee-financed FDIC in financial stress. Yet the Fed raised the discount rate to 0.75% on February 19, 2010. In contrast, in the five years prior to 2008, only 11 banks had failed from the debt bubble even when the discount rate stayed within a range from 2% to 6.25%.
Volcker, the Fearless Slayer of the Inflation Dragon
In the 1980s, to counter stagflation in the US economy, the Fed under Paul Volcker, (August 6, 1979 – August 11, 1987), fearless slayer of the inflation dragon, kept discount rate in the double digit range from July 20, 1979 to August 27 1982, peaking at 14% on May 4, 1981. From August 1982 to its peak in August 1987, the Dow Jones Industrial Average (DJIA) grew from 776 to 2722. The rise in market indices for the 19 largest markets in the world averaged 296 percent during this period.
Volcker, as chairman of the Fed before Greenspan, caused a “double-dip” recession in 1979-80 and 1981-82 to cure double-digit inflation, in the process bringing the unemployment rate into double digits for the first time since 1940. Volcker then piloted the economy through its slow long recovery that ended with the 1987 crash. To his credit, Volcker did manage to bring unemployment below 5.5%, half a point lower than during the 1978-79 boom, and the acknowledged structural unemployment rate of 6%.
Two months after Volcker left the Fed, to be succeeded by Alan Greenspan, the high interest rate left by Volcker, inter alia, led to Black Monday, October 19, 1987, when stock markets around the world crashed mercilessly, beginning in Hong Kong, spreading west to Tokyo and Europe as markets opened across global time zones, hitting New York only after markets in other time zones had already declined by a significant margin. The DJIA dropped 22.61%, by 508 points, to 1738.74 on Black Monday 1987. On October 11, 2007, the DJIA hit a high of 14198.10. On March 2, 2009, it lost almost 300 points, or 4.2%, to end at 6763.29, its lowest point since April 25, 1997.
By the end of October, 1987, stock markets in Hong Kong had fallen 45.8%, Australia 41.8%, New Zealand 60%, Spain 31%, the United Kingdom 26.4%, the United States 22.68%, and Canada 22.5%. Fundamental assumptions such as market fundamentalism, efficient market hypothesis and market equilibrium were challenged by events. Despite that dismal record in the 1980s, Volcker was appointed by President Obama two decades later as first Chair of the President's Economic Recovery Advisory Board on February 6, 2009.
The 1987 stock-market crash was unleashed by the sudden collapse of the safety dam of portfolio insurance, a hedging strategy made possible by the new option pricing theory advanced by Nobel laureates Robert C Merton and Myron S Scholes. Institutional investors found it possible to manage risk better by protecting their portfolios from unexpected losses with positions in stock-index futures. Any fall in stock prices could be compensated by selling futures bought when stock prices were higher.

This strategy, while operative for each individual portfolio, actually caused the entire market to collapse from the dynamics of automatic herd-selling of futures. Investors could afford to take greater risks in rising markets because portfolio insurance offered a disciplined way of avoiding risk in declines, albeit only individually. But the reduction in individual risk was achieved by an increase in systemic risk.
As some portfolio insurers sold and market prices fell precipitously, the computer programs of other insurers then triggered further sales, causing further declines that in turn caused the first group of insurers to sell even more shares and so on, in a high-speed downward spiral. This in turn electronically generated other computer driven sell orders from the same sources, and the market experienced a computer-generated meltdown at high speed.
The Unlearned Lesson of the 1987 Crash

The 1987 crash provided clear empirical evidence of the structural flaw in market fundamentalism, which is the belief that the optimum common welfare is only achievable through a market equilibrium created by the effect of countless individual decisions of all market participants each seeking to maximize his own private gain through the efficient market hypothesis, and that such market equilibrium should not be distorted by any collective measures in the name of the common good or systemic stability.

Aggregate individual decisions and actions in unorganized unison can and often do turn into systemic crises that are detrimental to the common good. Unregulated free markets can quickly become failed markets. Markets do not simply grow naturally after a spring rain. Markets are artificial constructs designed collectively by key participants who agree to play by certain rules. All markets are planned with the aim of eliminating any characteristic of being free for all operations. Free market is as much a fantasy as free love.

In response to the 1987 crash, the US Federal Reserve under its newly installed chairman, Alan Greenspan, with merely nine weeks in the powerful office, immediately flooded the banking system with new reserves, by having the Fed Open Market Committee (FOMC) buy massive quantities of government securities from the repo market. He announced the day after the crash that the Fed would “serve as a source of liquidity to support the economic and financial system.” Greenspan created $12 billion of new bank reserves by buying up government securities from the market, the proceeds from which would enter the banking system.

The $12 billion injection of "high-power money" in one day caused the Fed funds rate to fall by 75 basis points and halted the financial panic, though it did not cure the financial problem, which caused the US economy to plunge into a recession that persisted for five subsequent years. Worst of all, the monetarist cure for systemic collapse put the financial world in a pattern of crisis every decade: the 1987 crash, the 1997 Asian financial crisis and the financial crisis of 2007.

High-power money injected into the banking system enables banks to create more bank money through multiple credit-recycling, lending repeatedly the same funds minus the amount of required bank reserves at each turn. At a 10% reserve requirement, $12 billion of new high-power money could generate in theory up to $120 billion of new bank money in the form of recycled bank loans from new deposits by borrowers.

The Brady Commission investigation of the 1987 crash showed that on October 19, 1987, portfolio insurance trades in S&P 500 Index futures and New York Exchange stocks that crashed the market amounted to only $6 billion by a few large traders, out of a market trading total of $42 billion. The Fed’s injection of $120 billion was three times the market trading total and 20 times the trades executed by portfolio insurance.

Yet post-mortem analyses of the 1987 crash suggest that though portfolio insurance strategies were designed to be interest-rate-neutral, the declining Fed funds rate was actually causing financial firms that used these strategies globally to lose money from exchange-rate effects. The belated awareness of this effect caused many institutions that had not understood the full dynamics of the strategies to shut down their previously highly profitable bond arbitrage units.
The Rise of Hedge Funds
This move later led to the migratory birth of new, stand-alone hedge funds such as Long Term Capital Management (LTCM), which continued to apply similar highly leveraged strategies for spectacular trading profit of more than 70% returns on equity that eventual led it to the edge of insolvency when Russia unexpectedly defaulted on its dollar bonds in the summer of 1998. The Fed had to orchestrate a private-sector creditor bailout of LTCM to limit systemic damage to the financial markets. The net effect was to extend the liquidity bubble further – causing it to migrate from a distressed sector to a healthy sector.

The 1987 crash reflected a stock-market bubble burst the liquidity cure for which led to a property bubble that, when it also burst, in turn caused the savings-and-loan (S&L) crisis.
While the 1987 crash was technically induced by program trading, the falling dollar was also a major factor. Although the dollar had started to decline in exchange value by late February, 1985 due to US fiscal deficit, that decline had yet to reduce the US trade deficit, causing protectionist sentiment in the US to mount as the trade deficit swelled to an annual rate of $120 billion in the summer of 1985.
The Issue of Exchange Rates
In part to deflect protectionist legislation, US officials arranged a meeting of G-5 officials at the Plaza Hotel in New York on September 22, 1985 with the purpose of ratifying an initiative to bring about an orderly decline in the dollar, observing that “recent shifts in fundamental economic conditions among their countries, together with policy commitments for the future, have not been fully reflected in exchange markets,” and concluded that “further orderly appreciation of the main non-dollar currencies against the dollar is desirable,” and that the G5 members “stand ready to cooperate more closely to encourage this.” During the seven weeks following the Plaza Accord, G-5 authorities sold nearly $9 billion, of which the US sold $3.3 billion for other currencies, while speculators profited by shorting the dollar.
The dollar had declined to seven-year lows in early 1987 amid signs of weakness in the US economy while the US trade deficit continued to grow. Demand was sustained not by income but by debt. Public statements by Reagan Administration officials were interpreted in exchange markets as indicating a lack of official concern about the ramifications of further declines in the dollar.
On February 22, 1987, officials of the G5 plus Canada and Italy met at the Louvre in Paris to announce that the dollar had fallen enough. But despite heavy intervention purchases of dollars following the Louvre Accord, the dollar continued to decline, particularly against the yen. Market participants perceived delays in the implementation of expansionary fiscal measures in Japan expected after the Louvre Accord and talks of trade sanctions on some Japanese products heightened concern about tension in US-Japanese trade relations.

Following the Louvre Accord, the G-7 authorities intervened heavily in support of the dollar throughout the episodes of dollar weakness in 1987, and sold dollars on several occasions when the dollar strengthened significantly. Net official dollar purchases by the G-7 and other major central banks effectively financed more than two-thirds of the $144 billion US current account deficit in 1987. The US share of these purchases was $8.5 billion, and the share of the other G-7 countries was $82 billion, since the non-dollar export-dependent governments wanted desperately to halt the appreciation of their currencies.
Record US trade deficits and market perceptions that the G-7 authorities were pursuing monetary measures best suited to their own separate domestic economic objectives soon sparked a further sell-off of the dollar. This contributed to a worldwide collapse of equity prices which had risen to levels unsupported by fundamentals. The dollar’s decline gathered new momentum when the Federal Reserve under its new chairman Alan Greenspan moved more aggressively than its foreign counterparts to supply liquidity in the aftermath of the 1987 stock market crash which had been triggered by program trading on portfolio insurance derivatives arbitraging on macroeconomic instability in exchange rates and interest rates.
Domestic Accommodative Monetary Stance and Exchange Rates
The Federal Reserve’s actions under Greenspan in 1987 led market participants to conclude that the Fed would emphasize domestic market objectives with accommodative monetary stance, if necessary at the cost of a further decline in the dollar. By year-end, the dollar's value had fallen 21% against the yen and 14% against the mark from its levels at the time of the Louvre Accord while Greenspan, the wizard of bubble-land, was on his way to being hailed as the greatest central banker in history. Two decades later, by 2007, the Greenspan put was called by the market and trillions of dollars were lost.
The Issue of Unemployment
Half a century before 1987, beginning in 1921, deflation had descended on the US economy like a perfect storm from Fed tight monetary policy under Chairman Daniel R. Grissinger, with farm commodity prices falling 50% from their 1920 peak, throwing farmers into mass bankruptcies. Business activity fell by one-third; manufacturing output fell by 42%; unemployment rose fivefold to 11.9%, adding 4 million to the jobless count.
Since mid-2007, the US has lost over 6 million jobs, with 4.4 million jobs lost in the first year of the Obama administration. Latest government estimate puts the Great Recession of 2008 as having lost 8.4 million jobs thus far and no more than 1.4 million jobs are expected to be restored by the end of 2010. Unemployment is expected to stay near double digit for the foreseeable future. If workers who have given up looking for work are also counted, the unemployment rate is close to 14% in 2010.
Some are attempting to put a positive spin on US jobs numbers for February 2010 when the unemployment rate, though still at 9.7%, held steady. The economy shed 36,000 jobs in January, but the good news was that the pace of job loss was moderating. An average of 27,000 jobs was lost each month since November 2009, compared with 727,000 jobs a month on average over the same period in 2008. When the laws of gravity says what goes up must eventually come down, there is no law that say what goes down will eventually come back up. That is how swimmers get drown; they float back up only after life has long left the body. Only dead bodies float naturally.
While the unemployment rate is rising more slowly, it seems likely to remain high. And despite the recent policy insistence that the top three priorities are jobs, jobs and jobs, both Congress and the Obama administration are not taking concrete steps to create them quickly beyond the usual lukewarm tax incentives.
By February 2010, 8.4 million jobs have been lost since the financial crisis began in July 2007. The normal 2.7 million jobs needed to absorb new workers coming into the economy were never created, leaving the economy bereft of 11.1 million jobs. To fill that cumulative employment gap while keeping a growing work force fully employed would require more than 400,000 new jobs a month for the next three years, considerably in excess of even the most optimistic projections under current job creation policies and programs. Further, healthcare reform, if it is expected to save cost, will inevitably include a reduction of jobs.
Five states reported new highs for joblessness in January 2010: California, at 12.5%; South Carolina, 12.6%; Florida, 11.9%; North Carolina, 11.1%; and Georgia, 10.4%.
Michigan’s unemployment rate is still the nation’s highest, at 14.3%, followed by Nevada with 13% and Rhode Island at 12.7%. South Carolina and California rounded out the top five.
Employers are unlikely to make new hires until they can profitably restore their current part-time work force to full time. In the private sector, just restoring hours cut during the recession will neutralize the equivalent of 2.8 million new jobs.
Congress is taking its time debating an undersized jobs bill that is not expected to create anywhere near the jobs that the economy needs in 2010. The good news is that during the second half of 2010, the economy will get a temporary, one-time job boost from the taking of the census, which will hire about one million minimum wage temporary workers. The danger is that misleading job statistics will allow both the Administration and Congress to avoid meaningful job creation commitments needed for a genuine recovery. Going forward, a jobless recovery has become a given when the recovery finaly comes.
Public Sector Layoffs
The next unemployment trouble will come from the public sector. Without timely and adequate Federal aid, the states and local governments will be forced by falling tax revenue to tighten fiscal budgets, which will mean layoffs and cancelled private contracts, both of which would squeeze demand in the private sector to further reduce local government revenue in a downward spiral.
The Fed’s Deflationary Bias
Back in 1921, when the economy came to a screeching halt, the Fed’s monetary ideological perspective was that declining prices were the goal, not the problem; unemployment was necessary to restore US industry to a sound financial footing, freeing it from wage-pushed inflation. Potent medicine always came with a bitter taste, the central bankers explained. The bitterness was assigned to the worker, while the sweet success was kept for capital.

The Dominance of the New York Fed and Internationalism

In 1913, farmers supported the establishment of a central because they had hope a central bank would not be controlled by moneyed interests in the Northeast. But their hope was dashed in 1921, when a technical process inadvertently gave the New York Federal Reserve Bank, which was closely allied with internationalist banking interests, preeminent influence over the Federal Reserve Board in Washington, the composition of which had originally represented more balanced national and regional interests.
The initial operation of the Fed did not use the open-market operation of buying or selling government securities as a method of managing the money supply. Money in the banking system was created entirely through the discount window at the regional Federal Reserve Banks. Instead of buying or selling government bonds, the regional Feds accepted “real bills” of trade, which when paid off would extinguish money in the banking system, making the money supply self-regulating in accordance with the “real bills” doctrine of money. The twelve regional Feds bought government securities not to adjust money supply, but to enhance their separate operating positive cash flow by parking idle funds in interest-bearing yet super-safe government securities. While the regional Feds did not need to make a profit, they felt a need to avoid incurring negative cash flow with the effect of inflating the money supply. They viewed their mandate as providing monetary support to their respective regional economies.

Bank economists at the time did not understand that when the regional Feds independently bought government securities, the aggregate effect would result in macro-economic implications of injecting “high power” money into the banking system, with which commercial banks could create more money in multiple by lending/depositing recycles through partial reserve banking regulations.
When the Treasury sold bonds, the reverse would happen. When the Fed made open market transactions, interest rates would rise or fall accordingly in financial markets. And when the regional Feds did not act in unison, the national credit market could become confused or become disaggregated, as one regional Fed might buy while another might sell government securities in its open market operations.

Benjamin Strong, the first president of the New York Federal Reserve Bank, saw the problem and persuaded the other 11 regional Feds to let the New York Fed handle all their transactions in a coordinated manner. The regional Feds agreed to form an Open Market Investment Committee for the purpose of maximizing overall profit for the whole system, being unaware that they were signing away their separate prerogative to support their respective regional economies.
This new Committee was dominated by the New York Fed, which was closely linked to big international money-center bank interests which in turn were closely tied to international financial markets in which the New York banks were also key participants. The Federal Reserve Board approved the arrangement without full understanding of its full implication: that the Fed was falling under the undue influence of the New York internationalist bankers who were more interested in the value of the currency than the health of the economy, particularly the regional economies. This fatal flaw would reveal itself in the Fed’s role in causing and its impotence in dealing with the 1929 crash and all subsequent market crashes.

While the Fed was careful not to expand the money supply, money was created by the rising use of margin in the stock market. The deep 1920-21 depression eventually recovered into the margin-fed speculative Roaring Twenties, which, in many ways similar to the New Economy debt bubbles of the 1990s and 2000s, left some segments of economy and the population in them lingering in a depressed state amid general prosperity. Farmers remained victimized by depressed commodity prices and factory workers shared in the prosperity only by working longer hours and assuming debt with the easy money that the banks provided. Unions lost 30% of their membership because of high unemployment. The prosperity was entirely fueled by the wealth effect of a speculative boom in the stock market that by the end of the decade would face the 1929 crash and land the nation and the world in the Great Depression.
Historical record showed that when New York Fed president Benjamin Strong leaned on the other eleven regional Feds to ease the discount rate on an already overheated economy in 1927, the Fed lost its last window of opportunity to prevent the 1929 crash. Some historians claimed that Strong did so to fulfill his internationalist vision at the risk of endangering the national interest.
The Dangerous Influence of Milton Friedman

Milton Friedman, in his widely praised study of the monetary causes of the Great Depression, focus on the role of the Fed by claiming a counterfactual insight that had the Fed responded to the 1929 crash with massive monetary easing, the Depression would have been avoided. In the decades from 1978 to 2007, Greenspan and Bernanke, both faithful Friedmanesque doctrinaires, relied on the Friedman monetary cure to postpone the inevitable day of reckoning of debt-fueled speculation, in a market where on top of Fed easing of the money supply, money was being created without limits by the use of high leverage by financial manipulators. Hedge funds and investment banks were routinely using leverage at 40 to1 (bypassing the regulatory limit of 12 to 1) as an industry standard for structured finance to make bet on minute market movements to produce unsustainably high returns that posed dangerous systemic risk to globalized financial markets. 

When money is not backed by gold, its exchange value must be managed by government, more specifically by the monetary policies of the central banks. Yet central bankers in the 1920s tended to be attracted to the gold standard because it can relieve them of the unpleasant and thankless responsibility of unpopular monetary policies to sustain the value of money. Central bankers have been caricatured as party spoilers who take away the punch bowl just when the party gets going.

Yet even a gold standard is based on a fixed value of money to gold, set to reflect the underlying economical conditions at the time of its setting. Therein rests the inescapable need for human judgment. Instead of focusing on the appropriateness of the level of money valuation under changing economic conditions, central banks often become fixated on merely maintaining a previously set exchange rate between money and gold, doing serious damage in the process to any economy out of sync with that fixed rate. Economies that do not produce or possess a flexible supply of gold will be penalized by the inability to vary their money supply to meet the needs of their economies.  Central bankers do not understand that the problem is the currency’s fixed rate to gold and not the varying monetary needs of a dynamic economy.
When the exchange value of a currency falls, central bankers often feel a personal sense of failure, while they merely shrug their shoulders to refer to natural laws of finance when the economy collapses from an overvalued currency.
But the effectiveness of central bank intervention in the money markets is steadily reduced by the ability of market participants to create money through the extending of credit. The sub-prime mortgage syndrome was essentially a private sector money printing press over which the Fed had no control since it ideologically placed faith in the unregulated market’s inherent ability to self correct. While this faith has now been fully discredited, regulatory reform is still stuck the political quicksand of special interest lobbying. More than two years after the outbreak of the global financial crisis, the financial markets are essentially still operating under the same regulations that brought them to a near meltdown. 
April 25, 2010
Next: Global Sovereign Debt Crises