Friedman on the Great Depression and bank runs

Money Supply

Friedman’s colleague, Anna Schwartz

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(1) Reason.com – Defaming Milton Friedman (Naomi Klein) http://www.reason.com/news/show/128903.html

(2) Wall St. Journal – Bernanke Is Fighting The Last War http://online.wsj.com/article/SB122428279231046053.html

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Next in Lies, Damned Lies and Statistics Series: Part 4: Iraq War Casualties
Previous in Lies, Damned Lies and Statistics Series: Part 2: Income Stagnation
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Anyone who’s read my posts can tell I have pretty strong libertarian leanings. So in this post, I’m going to try to remain fair and take on a common libertarian statistic. In the documentary film, Fiat Empire, libertarian congressman Ron Paul restates an oft-cited fact by libertarians, “If you study monetary history, throughout thousands of years, paper money has been tried many, many times and it never succeeds. It always ends badly.” (1)

A fiat currency is simply a currency that isn’t backed by any underlying asset. Fiat currencies derive their value solely from the ratio of money to goods in the economy. If that ratio gets out of whack (say the government prints too much money), the currency will become worth less than the paper it’s printed on. Ron Paul and many libertarians, especially those who ascribe to Austrian economics, believe in the gold standard (where each unit of currency is backed by gold, a proposal I have a lot of sympathy for). And since every fiat currency that has ever existed has failed, all the more reason we should go back to the gold standard. Now, the statement that every fiat currency has failed is completely true. It’s also completely meaningless.

First we have to boil down what these libertarians are actually talking about here. A failed fiat currency is one that hyper-inflates. There are certainly numerous examples of this throughout history. The most famous example is Weimar Germany in between the two World Wars. In 1914, 4.2 marks were worth 1 dollar. In 1923, 4.2 trillion marks equaled one dollar! In case you were wondering, this is bad for an economy. Other examples include the Romans, who experienced severe runaway inflation near the end of their empire, France in the late 18^th century, Hungary after World War II, many Asian countries during the Asian Financial Crisis of 1997 and Zimbabwe today. (2)

The moral of the story is all fiat currencies hyper-inflate, while those backed by gold don’t (they can however suffer from high inflation in the short term). (3)  As I said, these libertarians are correct. As the Daily Reckoning puts it: “EVERY fiat currency, since the Romans first began the practice in the first century, has ended in devaluation and eventual collapse.” (4) There are two caveats to their argument, though: 1) if the fiat currency was ended for another reason, say the country was conquered and the currency replaced, then those examples are obviously ignored and 2) if the currency is still around today*, it also doesn’t count, because the currency will presumably fail in the future. The problem with this assessment is simple: What else can happen to a currency?

The answer to that question is nothing. The only possible exception would be the hypothetical hyper-deflation. This isn’t even worth talking about though, since it has never happened in the history of the world and would have to get so out of hand that one unit of currency was worth everything on the planet (otherwise you could just print more or cut the currency up into smaller pieces, like when a stock splits). Other than such an absurd scenario, there are only three options for a fiat currency: hyperinflation, ended by another means or it still exists. So while this statistic/fact is completely true, it’s also akin to saying the sky is blue (and about as useful for determining monetary policy).

There are plenty of reasons to support the gold standard. Gold standards reduce inflation and prevent governments from taxing the population in a hidden way. This thereby makes it more difficult for governments to wage wars or reward their friends in the private sector. The “fact” that every fiat currency has failed (excluding the two obvious caveats) does nothing to help the argument, though. It sounds like it conveys something, but in actuality, it conveys absolutely nothing.

___________________________________________________________________________________________________ Lies, Damned Lies and Statistics Series

Part 1: A Primer
Part 2: Income Stagnaton
Part 3: All Fiat Currencies Fail
Part 4: Iraq War Casualties
Part 5: Female-Male College Gap
Part 6: Male-Female Wage Gap
Part 7: Roger Maris’ Asterisk
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*Every currency in the world today is a fiat currency.

(1) Ron Paul, Fiat Empire, Matrixx Entertainment, 2006, http://vids.myspace.com/index.cfm?fuseaction=vids.individual&videoid=41426337
(2)  “Toilet Paper Money,” Whiskey and Gunpowder, 4/17/2007,  http://whiskeyandgunpowder.com/toilet-paper-money/#hidehttp://seekingalpha.com/article/127585-the-gold-standard-and-inflation
(3) Stephen Yu, “The Gold Standard and Inflation,” 3/24/2009, http://seekingalpha.com/article/127585-the-gold-standard-and-inflation
(4) Nick Jones, “Fiat Currency – Using the Past to See the Future,” The Daily Reckoning, http://dailyreckoning.com/fiat-currency/

By expanding the money supply, central banks everywhere have been able to push nominal interest rates to zero. In some countries, real interest rates have plunged into negative territories; lending at real negative returns sounds really appealing, doesn’t it? While increasing the money in circulation, troubled banks and companies like GM have been able to survive. Select industries have remained afloat, continued to employ some (although severe cutbacks have still occurred at General Motors, and they have moved thousands of jobs to places like Mexico, China and South America to take advantage of the lower wages), and banks who received TARP funds are beginning to give the money back to the Treasury.

But if the economy doesn’t turnaround in a meaningful way by the end of President Obama’s first term, what is the next move for central planners? Just when you think they’ve ran out of bullets, they pull out a golden gun. Could the next move be a nudge towards a cashless society? Whispers of such an about-face have turned into legitimate policy debates in Japan. The total shift to electronic money would be designed, and sold to the Japanese people, as a way to fight the deflationary spiral they’ve battled for a decade plus (coined “the lost decade”). Nothing scares the central bankers more than deflation. And nothing works better to push through policy than fear. Americans have learned all about fear mongering through both the Bush and Obama administrations.

Some analysts have estimated the Japanese need around -4 percent nominal interest rates to fend off further deflation. If I’ve lost you, that’s just your gut kicking in. A monetary system that requires -4 percent rates to kick-start an economy, is obviously a flawed one. The only way to achieve such low interest rates, claims the argument, is by controlling the money supply exactly down to the dollar, or yen, in this case. When central bankers use open market operations to control the money supply, they buy and sell bonds to increase or decrease money in circulation. Buying bonds increases the money supply; selling bonds decreases the money supply. A target interest rate is not hit precisely; rather, the rates jump around a range, close to the target. With a fractional reserve banking system, the money supply is even more difficult to pinpoint.

As Minority Report as it sounds, we’re oddly not that far from the cashless, central banker’s nirvana. In the United States, roughly 97% of the money supply is electronic. We use eBills, eStatements, online banking and pay for most goods with debit or credit cards.

Japanese policymakers will have a harder time convincing their cash-based, savings-oriented consumer society to use eMoney. “Only” 84% of the money supply is electronic in Japan. Six cashless payment systems exist under the Osaka sun (although only a city, the sun in Osaka reaches all corners of the country. Or, I just wanted to use the term), with growing technology that embeds the systems into mobile phones. All totaled, 120 million cashless payment chips (cards or phones) have made their way into the Japanese consumer’s routine.

I’m not expert enough to explain why anybody would lend money at negative interest rates; or, pay the government for the privilege of holding their debt. Practically, negative nominal rates are impossible. But negative real interest rates are already here. A nominal rate of zero, plus whatever the inflation rate currently sits at, puts us at negative real interest. The increase in food and gas prices is probably enough to get most baskets of goods and services to a higher inflation rate than last quarter.

As Milton Friedman said:

“I have been fascinated by the fact that in country after country you have a paradox: you have what is supposed to be a government of the majority; you have a representative government. And yet that government repeatedly does things that a majority of the people oppose. You go around in the United States, for example, where I know the situation best, and you will find that a majority of the people in the United States think government is spending too much, imposing taxes that are too high and would like to see government cut back. At the same time, the representatives of the people…through the…Congress…follow policies that lead to those results that the majority deplore. The reason for that, I believe, is we have a defect in our government institutions. What we have is a situation in which minorities, special interest minorities, are able to exercise undo influence. In my opinion…our solution to that is going to be through public action, which will lead to Constitutional provisions, setting narrower limits on government. That was a device that was adopted in the 18th century by the founders of our country in the original Constitution, and we need to reinforce that…by using the Constitution to set narrower limits on the scope of government.”

Without cash, every transaction we make will be recorded, and traced back to us directly. It will be even easier for the Federal Reserve, a non-government entity with zero transparency, to manipulate the money supply (thus changing the value of money). Currently, when Federal Reserve Chair Ben Bernanke doesn’t want to answer a question on Capitol Hill, he claims “banker’s privilege.” For an institution moving around trillions of dollars, not to mention holding the ominous power of creating new money, how long can this arrangement stand? A cashless society also brings us closer to the possibility of all financial, if not personal, information like social security numbers, compiled in one place; perhaps a government card, or for the New World Order folks, a scan-able chip implanted in the back of the hand.

The good news is, a computer’s voice will be able to tell me which pants I might like, as I stroll into the Gap.

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Negative nominal interest rates do occur in everyday life. Usually they are special cases, and not suitable for overarching monetary policy. For practical examples of negative nominal interest, check out an article by Alex J. Pollock:

Why Not Negative Interest Rates?

Fiat money simply means that our money isn’t backed by anything. We can’t go to our bank and trade it in for gold or silver; it holds value simply because everyone accepts that it holds value; value which is determined by the amount of money in the economy relative to the overall productivity of the economy.

Fractional reserve banking means that banks only have to keep a certain percentage of their deposits on reserve. Let’s say that you deposit $100 at a bank and the reserve requirement is 10%. This means the bank keeps $10 and can loan out the other $90, thus, creating $90 out of thin air, as both the depositor and the borrower have claim on that $90. That $90 will presumably be deposited in another bank and the process repeats itself as $81 will be created, and so on. In the end, for every $100 initially deposited, $900 new dollars will “magically” appear in the form of bank credit.

The Federal Reserve acts as a lender of last resort, in case bank runs threaten to destabilize the system. The Fed is also in charge of managing the banking sector and maintaining the “optimal” amount of money in the economy. That we believe there is an “optimal” amount of money to be had, the economy is a bit odd in the first place. It lead famed economist Murray Rothbard to ask, “How come, after all… no one addresses the question: what is the “optimal supply” of canned peaches today or in the future?” (1) Regardless, the Fed sets the reserve requirement and controls the money supply through a host of other different methods I need not discuss here.

The Fractional, I mean, Federal Reserve

Two things immediately strike me as strange about this arrangement. First, that banks create money whenever they make a loan (or the Fed can create it at a whim, usually by monetizing government debt). Second, that two, or more, people have claim to the exact same asset. If you put your $100 in the bank, you presumably hold title to that $100. However, $90 of it (assuming a 10% reserve requirement exists) will also be “owned” by whoever borrowed your money from the bank as well. This situation has no parallels that I’m aware of. It’s true that there can be complex ownership structures: say I buy a piece of property with two loans, a first for 80%, through Bank of America and a second for 20%, through a private lender, then put that property in a trust that is part of a larger partnership based in the Cayman Islands, which I co-own with several other people. I then lease that property out to someone with an option to buy in two years. He, in turn, subleases it to someone else, who rents out the extra rooms to his friends. Yeah, that’s a tangled mess, but eventually, if you work your way through said mess, I am still the sole-owner of that property. Not true when it comes to bank deposits.

The reason banks can do this, legally speaking, is rather strange. Way back in the day, when there was no real legal precedent, bankers just figured fractional reserve banking would be a good, if morally dubious, way to make extra money. The idea permeated its way throughout banking all over the world, but only became codified as law after the British case of Carr v. Carr in 1811, in which the judge stated that deposits were essentially loans to banks and as long as they repaid their depositors, they could do with those deposits as they wished (bet you didn’t think of your checking account that way). This definition is in stark contrast to, what is legally called, a bailment. Or in plain English, if deposits were considered bailments, the bank would act as a warehouse for your money.

The difference between a loan and a bailment, for all intents and purposes, is the same as the difference between fractional reserve banking and 100% reserve banking. In 100% reserve banking, banks simply act as warehouses for capital. For simple checking accounts, bank customers would probably have to pay a small fee to keep their money in the bank, instead of receiving interest. It would be like putting your money in a safe deposit box. Bank’s primary purpose would be to invest people’s money for them, in the form of loans to others and then charge a fee or percentage of the interest for the service of bringing the lender and borrower together. Since the bank must maintain 100% of the money entrusted to it on reserve, it could not allow customers to withdraw their funds on demand. Instead, customers would likely have to sign contracts that prevented them from getting their money back for a certain period of time.

All this may sound like a big headache and make fractional reserve banking sound more appealing, despite its many questionable aspects; however, there are major advantages to 100% reserve banking. Right off the bat, banking panics are simply impossible. Since every bank has all its money on hand (or its customers aren’t contractually entitled to it at that time), there is no way that a run on the bank will cause a bank to go under. And therefore, large banking crises, such as the one we are seeing today, or saw in the Great Depression, or in the panics of 1819, 1837, 1857, 1871, 1893, 1907, etc. would never happen.

Furthermore, Austrian economists, such as Nobel Prize winner F.A. Hayek, argue that the artificial increase in bank credit (through the Federal Reserve and fractional reserve banking) causes the boom/bust cycle most people think is just an unfortunate side effect of a market economy. The theory, summarized briefly, states that as credit is increased artificially, the market starts off on an uncontrollable boom. People, flooded with cheap credit, start more projects than available resources can complete. Once it becomes evident that many of these projects are unfeasible, the boom shifts rapidly to a bust and the economy goes into a recession. This theory is by no means accepted by all, or even most economists. Paul Krugman equated it to “phlogiston theory of fire” (3) and Milton Friedman said, “It is, I believe, false.” (4) Both of them have also won the Nobel Prize in economics.

I’m not going to do a detailed analysis of which side is right (I personally lean toward the Austrians), because the case for a 100% reserve requirement doesn’t need it. And the big key in my opinion is that a 100% reserve requirement would end the credit/consumption based economy and replace it with an economy based on savings. One extraordinarily important problem with a fiat money, fractional reserve banking system is that all new money is created as debt!* A 100% reserve standard would, presumably, come with a gold standard (each dollar could be redeemed for a certain amount of gold). This means that new money would arrive on the scene attached with no debt. It was simply mined out of the ground. A fiat, fractional reserve system, to the contrary, attaches debt to every single new dollar since new money is created through bank loans. Every dollar introduced into the economy is a dollar that someone owes to someone else, usually a bank.

Furthermore, since fractional reserve banking creates a lot more money than could be mined out of the ground, it naturally has an inflationary effect. Inflation is a major disincentive for saving, since savings become less valuable as a currency depreciates; inflation acts as an incentive to spend now. And finally, with so much credit on the loose, credit cards and the like become more available and those damned impulse purchases become that much easier to justify. Thus, it is no surprise that Americans, for most of the decade, have had a negative savings rate (5) and a grand total of almost 14 trillion dollars in debt. (6) Its also safe to say this would not be the case in a 100% reserve system.

Household Debt - Source: Federal Reserve Bank of St. Louis

This system should obviously have an appeal to conservatives who long for the days when thrift was a personal value held in high esteem. It should also appeal to liberals who often chastise corporations and banks for shackling the poor and middle class with debt and call for government intervention on these people’s behalves.

Indeed, these liberals should ask if the banking system itself is fatally flawed. When thinking about what would happen if a 100% reserve standard were implemented, something that should interest every liberal comes to mind; namely, corporations would get smaller! Obviously, banks and major financial institutions would shrink because there would be much less credit available to lend out. However, I believe, companies would become smaller throughout the entire economy.

It would work like this: right now, credit is cheap (due to fractional reserve banking and the Federal Reserve). Therefore, the best long-term investments for individuals are usually not in the credit market, but in the equity market; namely stocks. The vast majority of individual’s retirement savings exist in mutual funds, 401K’s, IRA’s and other stock portfolios. All this provides capital to corporations, usually big corporations hedge fund managers believe to be safe investments. These corporations can then use this flood of capital to expand. However, if credit were tightened by implementing a 100% reserve standard, interest rates would go up significantly. This would drive capital away from equity purchases (stocks) and toward lending money. I imagine investment banks pooling people’s savings into bundles, which they would loan out to home buyers, entrepreneurs and other businesses. To compete for this capital, large corporations would either have to use debt to finance expansion or sell their stock cheaper or offer higher dividends, to attract investors. Thus, it would become more difficult for big businesses to attract capital, thereby spreading money more evenly throughout the rest of the economy.

If that’s not enough to peak the common liberal’s interest, it must be noted that since fractional reserve banking is inflationary, it acts as a regressive tax. Inflation is a tax because new money adds no wealth; it simply takes away from the purchasing power of existing money. The reason inflation is regressive is a bit more complicated. When new money is created, it doesn’t create inflation until it has had a chance to circulate throughout the economy. For example, say there are $10 dollars and 10 widgets in an economy. Each widget costs $1. If I pump in $10 more dollars, the widgets will be worth $2. However, since the economy isn’t some giant computer, it has no idea new money has been pumped in until after that money is spent. The widgets will still cost $1 until after they’ve been bought. So those who get the $10 I pumped in will be able to buy the widgets for $1, when they should have had to pay $2. In other words, those who get the money first get to buy at below market prices, while those who get the money last buy at above market prices.

Now, while everyone takes out a lot of debt these days, big businesses still take out much more credit than regular folks. Therefore, inflation acts as an almost perfectly regressive tax, redistributing wealth upwards. The poorest of the poor take out very little debt (aside by credit card debt, usually spent on consumables), the middle class take out a fair amount of debt (albeit, much more than they should) and the rich take out a lot of debt (mostly to invest in profit seeking ventures). Furthermore, this credit, whether loaned to the poor or rich, is paid back with interest to the banks, even though much of the money the bank loaned out was created out of thin air; receiving interest on nothing in some sense. Thus, the banks and government (which gets to spend new money immediately, usually in the form of monetized debt), benefit the most from this regressive tax. A tax that would be eliminated with a 100% reserve standard since bank loans would not create new money and inflation would be significantly curbed.

This is not to say 100% reserve banking (presumably with a gold standard and no Federal Reserve) is a perfect system. That it surely is not. Credit would certainly become more expensive and make it more difficult to buy a house. Deflation would probably set in too, since so much less money would be created. Most economists are scared to death of deflation; however, while major deflation destroys the incentive to lend, modest deflation isn’t a bad thing. It means nothing more than everything is getting cheaper, which should be a good thing.** Still, there’s no fool proof way to make sure every banker plays by the rules. Since some probably won’t, a bank here or there could still go under if they cheat. And since people would probably have to pay to keep their money at a bank, many could choose to hold onto their money, putting their savings at the mercy of thieves and disasters.

Some of these issues could be addressed with the proper regulation or even by market forces. Others might be worth the cost, given the advantages. 100% reserve banking is done, after all, in private lending all the time. The most common examples are “hard money” lenders who lend on real estate or venture capitalists who lend to start-ups. The Bank of Amsterdam even successfully used a system of 100% reserve banking from 1609 until the late 1800’s. (7) If nothing else, given our current financial mess, 100% reserve banking is at least something to think about.

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*For those more interested in this topic, I recommend the video “Money as Debt.” The whole series is about 50 minutes. I have a couple of reservations about it though. It dismisses the gold standard almost out of hand and recommends the government takes over credit, which is about the worst idea I’ve ever heard. It also assumes that because all money starts as debt, people will become more and more indebted until the banks own everything. This, however, neglects to account for increases in productivity. By productivity increasing, dollars gain what could best be described as equity, even though they started out as nothing more than debt. Regardless, it’s still a worthwhile video. You can find the first part here:

http://www.youtube.com/watch?v=vVkFb26u9g8

**Major deflation is certainly bad. It destroys the incentive to lend. Say if deflation was so out of hand, that market interest rates would be below 0%. No one would lend at this rate though, because it would be better to simply hold their money. Major deflation is especially bad if the government tries to implement wage or price controls which will throw the economy out of equilibrium and cause high unemployment and shortages (this is what happened in the Great Depression). However, the United States experienced modest deflation from 1870-1900 and saw massive economic growth during that time. Furthermore, in 2004, the Papers and Proceedings of the American Economic Review published a study of deflationary episodes in 17 countries over 100 years and found that, excluding the Great Depression, 90% of deflationary episodes did not result in a depression. (8)

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(1) Murray Rothbard, The Case Against the Fed, Pg. 18, Ludwig Von Mises Institute, Copyright 1994

(2) Ibid., Pg. 40-45

(3) Paul Krugman, “The Hangover Theory,” Slate, December 4^th, 1998

(4) Milton Friedman, “The Monetary Studies of the National Bureau, 44th Annual Report”, The Optimal Quantity of Money and Other Essays, Chicago: Aldine. pg. 261-284

(5) “Our Savings Rate Is (Still) Negative: Should We Worry,” My Money Blog, 2/4/07, http://www.mymoneyblog.com/archives/2007/02/our-savings-rate-is-negative-should-we-worry.html

(6) Series: CMDEBT, Houshold Sector: Liabilities: Household Credit Market Debt Outstanding, Federal Reserve Bank of St. Louis, retrieved June 11^th, 2009, http://research.stlouisfed.org/fred2/series/CMDEBT

(7) Murray Rothbard, The Case Against the Fed, Pg. 44n, Ludwig Von Mises Institute, Copyright 1994

(8) Quoted from Tom Woods, Meltdown, Pg. 138, Regnery Publishing Inc., Copyright 2009

In 1759, Voltaire wrote his satirical, Magnum Opus, Candide, eponymously named after the main character, who after leading a sheltered life for many years, comes to the realization that all is not right in the world, and we must do our best to improve it. This is in direct contradiction to his mentor, Pangloss, whose mantra is “all is for the best in the best of all possible worlds.” In other words, we are already living in a utopia, it simply cannot get any better, which he humorously (albeit darkly) explains to someone who just lost his whole family after an earthquake. The idea that war has a good side effect reminds me of the Leibnizian optimism (everything happens for the best) that Voltaire so thoroughly refuted. Some things, such as war, may be necessary, but they are in no way good, and have no silver lining.

War is horrible… but it’s good for the economy. I cannot, for the life of me, think of a more dangerous myth than that. This facade has become so prevalent in the national conscience that it’s simply taken for granted. The reasoning for this myth comes from an offshoot of Keynesian economics, in summary it says war stimulates aggregate demand and thereby gets the wheels of the economy turning again (or turning faster). The key piece of evidence used for this assertion is World War II, which is arrogantly claimed, over and over again, to have ended the Great Depression. As MSN Encarta so helpfully informs us, “the depression ended in the United States only when massive spending for World War II began.” Seriously though, why would anyone actually believe this without at least a little skepticism? Wars are enormously destructive and shift resources from human needs, to human destruction.

The key problem with the theory itself, is that such stimulus, military or otherwise, relies on government spending. The government doesn’t have anything except what it takes, it can do little more than shuffle the deck. Government can tax the population, inflate the currency (another tax) or borrow the money (a deferred tax). Deficits are usually the prescribed course of action, but if you borrow from your own citizens then you’ve simply used up capital that could have been borrowed by private citizens and companies anyways. This is especially true for domestic borrowing, but is also the case with borrowing from abroad. Regardless, as the government borrows more, the reduced supply of available capital will raise interest rates for everyone else. Admittedly, this may provide short-term growth, if investor confidence is low, but such a prescription has long-term consequences, as the debt has to be repaid with interest. And as with the United States, we’re already up to our eyeballs in debt. Furthermore, these benefits are only accrued if that money is spent on projects of economic value. Wars do not provide any economic value.

Keynesian economics can be discussed at further length another time; I’ll instead focus the rest of this article on the conspicuously lonely example proving the splendors of “military-Keynesianism.”

So let’s get to World War II. First of all, it’s obvious that conquest can help an economy in some cases. When the Soviet Union colonized Eastern Europe after World War II, their population, and supply of capital, vastly grew, which is obviously good for an economy. However, that’s simply saying that theft makes one richer. Not really the most provocative insight there. But what we’re discussing here is does the act of war itself stimulate an economy? Let’s for a moment assume that the popular fable behind World War II is correct. War is what got the United States out of the Depression. Okay, who cares? There’s one example of war stimulating an economy…Check that, there’s one example inside of a larger example that illustrates the exact opposite. Everything else points toward war having dire economic consequence. After World War II, Britain was basically bankrupt and had to liquidate their empire. Same goes for France. Germany, Japan and Italy were burnt to the ground. China was a train wreck before and an even bigger train wreck afterward. World War II only “worked” for the United States.

Furthermore look at the rest of the wars our species has, unfortunately, had to endure. The United States went into a severe recession in 1920, just after World War I. Germany’s currency hyperinflated while the Austrian, Ottoman and Russian Empires simply collapsed. In the American Civil War, the South was reduced to rubble and the North suffered runaway inflation. After the Revolutionary War, the American currency hyperinflated (thus the saying “not worth a Continental”). Rome’s collapse was mostly due to corruption at home and military over extension abroad. Napoleon was so strapped for money after the early stages of the Napoleonic War, he had to sell the Louisiana territories to the United States for pennies on the dollar.  The Franco-Prussian War was almost immediately followed by a speculative housing bust, which created the panic of 1873 and a global depression. Spain was more or less left to the ash bin of history, after the Spanish Armada was destroyed (shouldn’t there have been an enormous economic stimulus to rebuild?). The combination of spending on the Vietnam War and the Great Society lead to the stagflation of the 1970′s. In addition, the United States suffered recessions immediately following the Korean War, Gulf War and Serbian War. The Soviet Union collapsed after a long war in Afghanistan. Honestly, have the many sub-Saharan wars in Africa stimulated their economies? Has this economic strategy worked for Middle Eastern countries bogged down in decades of conflict? And really, if war is so good for an economy, why is our own economy collapsing all around us, while we are engaged in outrageously expensive boondoggles in Iraq and Afghanistan?

Perhaps this would prop up real estate prices?

Now correlation does not equal causation; not all the previously mentioned wars were completely, or even mostly responsible, for the corresponding economic upheavals. Regardless, it’s worth noting that I have about a thousand data points to make a trend, and the standard “wisdom” has but one outlier. Well one outlier proves absolutely nothing, so the burden of proof lies not with me, but with the standard “wisdom.” I should be able to end this article victoriously right here, but I feel it’s important to note, that upon closer analysis, even this one outlier is nothing of the sort.

Economic historian Robert Higgs’ work on this subject is simply unparalleled; if you are interested in a more detailed analysis of this issue, see his book Depression, War and Cold War or an overview here. Simply put, the case for World War II getting the United States out of the Depression, primarily lies with two statistics: 1) unemployment went from around 10% to almost nothing and 2) GDP skyrocketed upwards. We’ll start with unemployment, according to Robert Higgs:

“What actually happened was no mystery. In 1940, before the mobilization [for war], the unemployment rate … was 9.5 percent. During the war, the government pulled the equivalent of 22 percent of the prewar labor force into the armed forces. Voilà – the unemployment rate dropped to a very low level.” (1)

Yes, unemployment went down, but that’s because we shipped millions of young men overseas. We could have kept them in the United States and reduced unemployment by having them dig holes in the ground. Or we could have put them in prison, or just shot them. All these things would reduce the supply of labor, and thereby bring the number of jobs and workers back into equilibrium.

This sort of strategy has consequences though. What really happened during the war was the way the Depression affected the American people changed. The main problem during the Depression was deflation; between 1929 and 1932 one third of the money in circulation disappeared. Yet the government, (both Hoover and Roosevelt) tried to prop up wages and prices. This, predictably, caused massive unemployment, since there wasn’t enough money available to pay people their previous wages.  Back in the 1930′s there was a saying that “the Depression was not so bad if you had a job” which makes perfect sense, since wages were kept artificially high. (2)

During the war, the situation reversed itself. Just about everyone had a job, but the standard of living was drastically reduced. Price controls, rationing and shortages became commonplace. Housing starts stopped. Entire lines of products, such as steel, were off limits to the public. Now, instead of the unemployed feeling a lot of pain, everyone felt some pain.

As far as GDP goes, the statistics say the United States grew a total of almost 35% between 1941 and 1945. However, the United States had what could best be described as a command economy during the war. In other words, economic decisions for the whole country were made from the White House. The government set the prices for most goods (and rapidly inflated the money supply) so these GDP figures are all but useless. According to GDP statistics, if the government pays $100 for a hammer instead of $10, the economy gains $90. But that really doesn’t tell us anything about overall economic health. All it would tell us is the government wasted $90. As far as private production goes, things were not good at all. Turning again to Robert Higgs:

“…from 1941 to 1943, real gross private domestic investment plunged by 64 percent; during the four years of the war, it never rose above 55 percent of its 1941 level [and] only in 1946 did it reach a new high.” (3)

To further prove this point, we simply have to look at the end of the war, when the United States started to demobilize. The GDP decreased 20.6% in 1946 alone! This should be recorded as one of the worst years in economic history. However, 1946 saw extraordinary gains in the private sector that have never been repeated since. (4)

Notice the significant dip in 1946 - Source: Bradford Delong, Slouching Toward Utopia, UC Berkeley

So what ended the depression? Well, the fact that the United States was, more or less, the only country left standing after the war may have helped by putting our exports in high demand. However, this has nothing to do with war itself and trying to repeat this strategy to fix our current crisis seems to me just a bit, well a bit unethical. According to Robert Higgs, the actual key was the end to what he called “regime uncertainty.” In the later parts of the New Deal, the Roosevelt administration’s behavior had become unpredictable and many businesspeople were scared to invest. This was amplified during World War II, when much of the economy was simply taken over by the government. However, after the war ended, there was, to borrow a phrase from Warren Harding, a return to normalcy. The uncertainty was more or less over and people could, once again, pursue their personal interests in relative peace. This was what likely got the gears of the economy moving again and finally ended the Great Depression.

But again, even if professor Higgs and laymen, like myself, are wrong, we are only wrong about one example within an example. The rest of the trend points safely in our direction.

It’s also important to note that the burdens of war go on for many years after a war has ended. Completely ignoring the tragic human cost, the overall economy suffers as many soldiers are left wounded and can no longer work or work as productively as they could, before their service. A significant amount of money has to be spent to take care of injured soldiers as well. The Department of Veterans Affairs requested $93.7 billion dollars for 2009. These costs continue year after year. Even today, we see the heart-wrenching scene of disabled Vietnam veterans begging for money on street corners. Decades from now, we may, unfortunately, see the same from veterans of the war in Iraq, who could have lead quite productive lives, if they hadn’t been scarred by war.

Even the simple act of diverting resources away from the productive sector of the economy, into the military is costly. While being a soldier is a very honorable profession, it doesn’t produce much of economic worth. When the military becomes bogged down in a war, we transfer many resources from the production of consumer goods, to a war that is usually thousands of miles from our shores. And this doesn’t only happen in wartime, as the United States currently has about 700 military bases in 130 countries; all of which cost money without providing any sort of economic stimulus.

So war may improve artificially inflated GDP figures, temporarily reduce unemployment and even provide a short-term economic boost, it does not, however, stimulate the economy in any meaningful long-term sense. Quite to the contrary, Voltaire was right, Pangloss was wrong, and war often leads to economic disaster. In addition, the negative effects of wars, both economic and social, linger for years. Perhaps they linger just until we forget about them, so we can then repeat the same mistakes all over again. After all, the only thing we seem to learn from history, is that we don’t learn from history.

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(1) Quoted in Anthony Gregory, The Myth of War Prosperity, LewRockwell.com, April 3, 2007, Future of Freedom Foundation, Copyright 2007, http://www.lewrockwell.com/gregory/gregory132.html
(2) See Amity Shlaes, The Forgotten Man, Pg. 9, HarperCollins Publishers, Copyright 2007
(3) Quoted in Anthony Gregory, The Myth of War Prosperity, LewRockwell.com, April 3, 2007, Future of Freedom Foundation, Copyright 2007, http://www.lewrockwell.com/gregory/gregory132.html
(4) Ibid

A great question about deflation was sent my way and I’ve decided to share it with the community:

Why is deflation so “feared” by the media/politicians? Isn’t it the natural reaction when an overheated market’s bubble bursts and there is a significant reduction in prices to consumers. It appears this is happening in everything from electronics to gas to housing, etc. Isn’t this actually “good” because it gets prices set in a better position in the markets. I understand it is painful for the companies that now have to adjust their business models for the new reality in markets and also to employees that feel the effect with reduced income and unemployment. The employees will then have an opportunity to become employed by firms who are successful in structuring to the proper business models. Also other firms will enter new markets as firms fail.

All of this is painful in the short term but seem to me to be healthy in the long-run.

What say you?

SwiftEconomics.com Response:

I think you have the right idea here. Technically the “long-run” is defined by a period of time greater than one year. There is no cap on the long-run. No matter the economic situation, it could be said that it will be sunshine and lollipops in the long-run…2 years, 5 years or 20 years down the line. Other components to the “long-run” include a period where all costs are variable. This means a firm has the ability to enter or exit any industry and wipe clean all fixed costs of land, labor, factories and other capital goods as economic conditions change. The long-run allows for firms to adjust and remain competitive.

With the right mix of circumstances, deflation could be good for an individual. If a person still has their job, the same level of pay, and doesn’t hold assets such as housing and stocks, all of the sudden their real income improves without an adverse effect on their net worth (if assets such as housing and stocks fall in value so, too, does a person’s net worth who owns them).

Most economists would tell you “disinflation” is significantly better than “deflation.” Disinflation is a reduction in the rate of inflation. For example, the consumer price index goes from 3% in the first quarter to 1.5% in the second, but prices are still increasing. This gets back into monetary policy. The Fed likes small and gradual moves of inflation and the current system allows this by steadily increasing the money supply. Inflation is what creates “wealth” for most of the economy, especially consumers who own nest egg houses, classic cars and the like. Anti-monetarists argue that this is phony wealth and simply creates a money bubble (food for thought: Warren Buffet said he thinks the next bubble will be in the dollar). The short-run pain feared by economists, the media and politicians are the millions of jobs lost due to the slowing of markets and reduction in prices. If real estate prices never go up (and go down in many cases) and a potential tenant’s income doesn’t, how many banks will give out commercial loans to build new projects? And if these are the same banks who are hoarding bailout money to weather their sinking balance sheets, how much money have they made available for lending? Yeah, gas is as cheap as it’s been since March 2005, but Americans are still driving 5-10% less year to date.

What you describe is most effective in pure capitalism where capital was designed to find its way into profitable industries and soundly managed firms with products and services people demanded. Creative destruction killed off poorly ran companies and uncompetitive or irrelevant industries. We definitely don’t have that. The Big 3 automakers want a bridge loan because economic times are difficult. They believe they are the foundation of American manufacturing, just about ready to turn the corner and too important to fail. They should fail. I’m supposed to be impressed because they have a fossil fuel-burning engine SUV that gets 24 mpg in the city and 30 on the highway. Wow. Even if their cars were on par with their Japanese and Korean competitors, they’ve been so underwhelming in comparison for so long that it would take years to overcome the perception gap.

Deflation is the response to contagions and ultimately brings prices down to their equilibrium. The housing supply is far too great. Houses have to come down in value. This returns markets to a sensible and real valuation but it also puts people out on the streets in the short-run and increases bankruptcy. Bankruptcy sure makes it hard for consumers to buy $35,000 cars off GM, Ford and Chrysler lots.

In the long-run, even the Detroit Lions are a playoff team.