The Mechanics of a Depression

The bursting of a credit bubble is a deflationary event. In the case of the Great Depression is was massively deflationary. In order to understand how deflation happens, you need to understand how currency is created and how it can disappear.

When you or I take out a loan from a bank the bank does not actually loan us any of the currency that is on deposit at the bank. Instead, what it does is, the moment you sign that mortgage, loan document or credit card receipt the bank creates those dollars as an accounting, or book, entry. In other words, we create the currency and the bank or credit card company gets to charge us interest for the currency we just created. This brand new currency that we created then becomes part of the greater money, or more accurately, currency supply. Much of our currency is created in this way.

But when a house goes into foreclosure, a loan is defaulted on, or someone files bankruptcy the currency loaned against those assets disappears. So as credit is destroyed the currency supply contracts and deflation sets in.

This concept can be a little difficult to understand. During the Great Depression, and even more so today, money is a concept. Think about it for a moment. What is the U.S.Dollar based on today? What determines  its value? It is no longer based on gold or silver or any other precious metal, or anything tangible for that matter. The U.S. Dollar is a “fiat” currency. Many suggest that fiat currencies – all the world’s currencies are fiat by the way– are based on nothing. The value of the dollar floats against other currencies. It’s value is determined by how the dollar trades against other fiat currencies in the $4 trillion Forex market.

This is what happened in 1930-1933. As a wave of foreclosures and bankruptcies swept the country, one third of the currency supply of the United States simply evaporated into thin air. Over the next three years, wages and prices fell by a corresponding one third.

At the time, because our currency – the dollar – was backed by and fully redeemable in gold, there were constraints on the response of the Federal Reserve to these deflationary events. The Federal Reserve did not have the option of flooding the economy with fresh, newly minted or printed (or more appropriately today, electronically created) currency as it does today.

This explains, at least in part, why the Federal Reserve is creating trillions of dollars of new currency and pumping  it into the economy. They are desperately attempting, through the only policy action they know, to reinflate the currency supply, prop-up collapsing businesses and markets, and stave off deflation. Will their efforts be successful? That is the $64,000 question. Many support the approach, others believe it will result in inflation, or even hyperinflation. I believe they will ultimately fail and our economy will be plunged into deflation and depression.

Death of the Dollar

“When you or I write a check there must be sufficient funds in our account to cover the check, but when the Federal Reserve writes a check there is no bank deposit on which the check is drawn. When the Federal Reserve writes a check it is creating money.”

-The Federal Reserve, Putting It Simply, 1977

I disagree and believe it’s important to draw a distinction. The Federal Reserve does not create money, it creates currency.

And it is disconcerting the way the Federal Reserve creates that currency:

  • It makes loans to the government or banking system by writing a bad check.
  • It buys something with the bad check.
    And once those newly created dollars are deposited in the banks, the banks get to employ the miracle practice of fractional reserve banking, further debasing our currency – the dollar.
    Here is the definition of fractional reserve banking in a nutshell. All banks have a reserve requirement, meaning the must keep a certain amount of dollars available for withdrawals and other day-to-day requirements. If the reserve requirement set by the Fed is 10 percent (and it currently is) the bank must keep 10 percent of the currency deposited on hand in case someone wants to make a withdrawal. They are allowed to loan out the remaining 90 percent of those deposits.But the bank doesn’t actually loan out the currency that is in their depositor accounts. It creates brand new fiat dollars out of nothing and loans them out, which means that they too were “borrowed” into existence. In other words. when you deposit $1,000 dollars, the bank can create 900 brand new dollars with nothing but a book entry, and then loan them out with interest. This process repeats over and over again. If those 900 brand new dollars are deposited in a checking account, that bank is allowed to create another 90 percent of the value of that deposit, and then another 90 percent until that original $1,000 deposit becomes $10,000 freshly minted (actually electronically created) dollars. Is it any wonder why our nation’s money supply has exploded over the past few decades.
    Coincidentally, the same year the Federal Reserve Act was passed, 1913, the 16th amendment to the Constitution was approved, which created the dreaded income tax. And guess who championed the 16th amendment? None other than Senator Nelson Aldrich, one of the driving forces behind the formation of the Federal Reserve.

Faded Glory

The pattern of government war mongering, currency debasement, purposeful inflation, and excessive spending and growth of government is a pattern that has repeated throughout history. The pattern is nearly always the same:

  1. A sovereign government starts out with good money – money that is backed by something of tangible value, such as gold and silver.
  2. As the state develops economically and socially, it takes on more and more economic burdens, adding layer upon layer of public works and social programs.
  3. As its economic influence grows so does the country’s political and military influence.
  4. Eventually it puts its military to use and expenditures explode.
  5. To fund war, the costliest of mankind’s endeavors, the state steals the wealth of its citizens by replacing their money with currency that can be created in unlimited quantities. It does this either at the outbreak of war (as in the case of Weimar Germany in World War I), during the war (as in the case of Athens or Rome), or as a perceived solution to the economic ravages of previous wars (as in the case of John Law’s France).
  6. The wealth transfer caused by the expansion of the currency supply is felt by the population as consumer price inflation. Over time the inflation worsens, triggering a loss of faith in the currency.
  7. A massive movement out of the currency into precious metals and other tangible assets takes place; the currency collapses; and wealth is transferred to those who had the foresight to accumulate gold and silver early on.

An Inflation Tale

Nothing about the future is set in stone. Actions taken today do not inevitably lead to certain outcomes down the road, because something can happen tomorrow, or next week, or next year, that will negate what happened today. History seldom repeats itself – exactly. But this story about post-war Germany should make you take notice. The implications for our government’s monetization efforts are a little frightening.

At the beginning of World War I, Germany went off the gold standard. The government suspended the right of its citizens to redeem their currency (the mark) for gold and silver. That set the stage for massive currency inflation. The quantity of marks in circulation quadrupled during the war. Prices however did not keep up with the inflation of the currency supply. The effects of the currency inflation were not felt because the German people saved every penny they could lay their hands on, mainly out of fear and uncertainty. So even though the German government was pumping tons of currency into the system, no one was spending it.

But by the war’s end, confidence improved and the currency that had been hoarded by German citizens flooded into circulation creating price inflation.

Just before the end of the war, the exchange rate between gold and the German mark was about 100 marks per ounce. By 1920 the exchange rate was fluctuating between 1,000 and 2,000 marks per ounce – 10 to 20 times higher. Retail prices skyrocketed.

With war reparations to pay, the German government continued to print money at an astounding rate. In mid 1922 everything changed the economy began to collapse. The German people lost confidence in their currency. They realized if they hung onto their currency for any length of time they’d get burned – rising prices would wipe out their purchasing power.

To understand the scope of the German inflation maybe it’s best to start with something basic… like a loaf of bread. (To keep things simple we’ll substitute dollars and cents in place of marks and pfennigs.)  In the middle of 1914, just before the war, a one pound loaf of bread cost 13 cents.  Two years later it was 19 cents.  Two years more and it sold for 22 cents.  By 1919 it was 26 cents.  Now the fun begins.

In 1920, a loaf of bread soared to $1.20, and then in 1921 it hit $1.35.  By the middle of 1922 it was $3.50.  At the start of 1923 it rocketed to $700 a loaf.  Five months later a loaf went for $1200.  By September it was $2 million.  A month later it was $670 million (wide spread rioting broke out).  The next month it hit $3 billion.  By mid month it was $100 billion.  Then it all collapsed.

Let’s go back to “marks.”  In 1913, the total currency of Germany was six billion marks.  In November of 1923 that loaf of bread we just talked about cost 428 billion marks.  A kilo of fresh butter cost 6000 billion marks. That kilo of butter cost 1000 times more than the entire money supply of the nation just 10 years earlier.

How Could This Happen? In 1913 Germany had a solid, prosperous, advanced culture.  Like much of Europe it was a monarchy (under the Kaiser).  Then, following the assassination of the Archduke Franz Ferdinand in Sarajevo in 1914, the world moved toward war.  Each side was convinced the other would not dare go to war.  So, in a global game of chicken they stumbled into the Great War.

The German General Staff thought the war would be short and sweet and that they could finance the costs with the post war reparations that they, as victors, would exact.  The war was long.  They lost and, thus, it was they who had to pay reparations rather than receive them.

When things began to disintegrate, no one dared to take away the punchbowl.  They feared shutting off the monetary heroin would lead to riots, civil war, and, worst of all communism.  So, realizing that what they were doing was destructive, they kept doing it out of fear that stopping would be even more destructive.

People’s savings were suddenly worthless.  Pensions were meaningless.  If you had a 400 mark monthly pension, you went from comfortable to penniless in a matter of months.  People demanded to be paid daily so they would not have their wages devalued by a few days passing.  Ultimately, they demanded their pay twice daily just to cover changes in trolley fare.  People heated their homes by burning money instead of coal.  (It was more plentiful and cheaper to get.)

The middle class was destroyed.  It was an age of renters, not of home ownership, so thousands became homeless.

But the cultural collapse may have had other more insidious effects.

It was still the era of arranged marriages.  Families scrimped and saved for years to build a dowry so that their daughter might marry well.  Suddenly, the dowry was worthless – wiped out.  And with it was gone all hope of marriage.  Girls who had stayed prim and proper awaiting some future Prince Charming now had no hope at all.  Social morality began to collapse.  The roar of the roaring twenties began to rumble.

Belief in systems, governmental or otherwise, collapsed.  With its culture and its economy disintegrating, Germany saw a fringe character named Hitler begin a ten year effort to come to power by trading on the chaos and street rioting.  And then came World War II.

I’d like to close this review with a statement from a man whom many consider (probably incorrectly) the father of modern inflation.  John Maynard Keynes wasn’t writing about some abstract economic issue; he was talking about Germany as it was setting itself on a path of self-destruction. Here’s what Keynes said on the topic in 1919:


“By a continuing process of inflation, governments can confiscate, secretly and unobserved, an important part of the wealth of their citizens.  By this method they not only confiscate, but they confiscate arbitrarily; and, while the process impoverishes many, it actually enriches some…..Those to whom the system brings windfalls….become profiteers.

“To convert the business man into a profiteer is to strike a blow at capitalism, because it destroys the psychological equilibrium which permits the perpetuance of unequal rewards.

“Lenin was certainly right.  There is no subtler, no surer means of over-turning the existing basis of society than to debauch the currency. The process engages all the hidden forces of economic law on the side of destruction, and does it in a manner which not one man in a million is able to diagnose….By combining a popular hatred of the class of entrepreneurs with the blow already given to social security by the violent and arbitrary disturbance of contract….governments are fast rendering impossible a continuance of the social and economic order of the nineteenth century.

Rome Is Burning

By a continuing process of inflation, governments can confiscate, secretly and unobserved, an important part of the wealth of their citizens. By this method they not only confiscate, but they confiscate arbitrarily; and, while the process impoverishes many, it actually enriches some…..Those to whom the system brings windfalls….become profiteers.

-John Maynard Keynes

People think currency, such as the U.S. Dollar, is money. It is not. Historically money has an intrinsic value within itself. Think of gold and silver and other precious metals – they are money. Our paper and coins are fiat currency. A fiat currency is an arbitrary order, given by a body, typically a government, which has the power to enforce it. All currencies today are fiat currencies.

Here’s a dirty little secret: Fiat currency is designed to lose value. Its very purpose is to confiscate your wealth and transfer it to the government. Government monetary policy as implemented with our fiat currency – the U.S. Dollar – is a “hidden tax” on all of us. Consider this: every time the government prints a new dollar and spends it, the government gets the full purchasing power of that dollar. Where did that purchasing power come from. It was taken from the dollars you hold in your wallet, savings or investments. As each new dollar enters circulation it devalues all the dollars in existence because they are now more dollars chasing the same amount of goods and services. This causes prices to rise. This is the insidious stealth tax of inflation.

Rome supplanted Greece as the dominant power of the ancient world. During Rome’s centuries of dominance it achieved greatness in many ways. However, as with every empire in history, Rome did not learn from mistakes of the past. As a result they were doomed to repeat them.

Over the course of 750 years various leaders inflated the Roman currency supply by debasing their coinage to pay for war, public works and welfare. Coins were made smaller or a portion of the edge of gold coins were clipped off as a tax when entering a government building. The clippings would be melted down to make more coins. And, just as the Greeks did, the Romans mixed common metals such as copper into their gold and silver. And last but not least they invented the “art” of currency revaluation – they minted the same coins with a higher face value on them.

By the time emperor Diocletian took the throne in 284 A.D., Roman coins were nothing more than tin-plated copper or bronze. Inflation was raging.

In 301 A.D. Diocletian issued his infamous Edict of Prices, which imposed the death penalty for anyone selling goods for more than the government mandated price. The edict also froze wages. Prices, however, just kept rising. Merchants who could no longer sell their goods at a profit just closed up shop. People either left their careers to seek work where wages weren’t fixed or they just gave up and and accepted welfare from the state. In fact, the Romans invented welfare. Rome had a population of about one million and during this period of time the government was doling out free wheat to about 200,000 citizens – 20 percent of the population. Today in the United States nearly 43 million – about 14 percent of the population is on food stamps.

Diocletian put people to work by hiring thousands of new soldiers and funding numerous public works projects (I wonder if they were shovel ready?). This effectively doubled the size of the government and military. Today in the United State more that 1.9 million people, excluding the Postal Service, work for the federal government alone. When you include all branches of the federal government, and state and local governments the total approaches 22 million. See the Bureau of Labor Statistics website for details.

Of course all these additional government employees had to be paid and the government had to find a way to pay for its welfare programs. Deficit spending went into overdrive. When he ran short of funds, Diocletian simply minted new copper and bronze coins and further debased the Roman currency.

This resulted in the world’s first documented hyperinflation. At the time of Diocletian’s Edict or Prices a pound of gold was worth 50,000 denari. By 350 A.D. a pound of gold was worth 2.12 billion denari. The price of gold rose 42,400 times in about fifty years. Currency based trade came to a standstill. The Roman economic system reverted to a barter system.

To put this in perspective, fifty years ago the price of gold was $35 an ounce in the United States. If it rose 42,400 times, the price today would be just under $1.5 million dollars an ounce. That means, for example, that if a new car sold for $2,000 fifty years ago (which is about what they sold for), that same car would sell for $85 million today.

It was the deficit spending and currency debasement used to fund the military, public works and social programs that collapsed the Roman Empire. As with every empire throughout history the Romans thought they were immune to the laws of economics. They were not.