lived through those periods of panics and crashes. And while I think the Fed now acts in ways that are inappropriate (how can 12 FOMC board members purport to fine-tune an economic cycle, let alone solve employment problems?), the one true and proper role of the Fed is to provide liquidity in time of a crisis.
“People Who Live Too Much on Credit”
At the end of the day, it was too much debt that was the problem in 1873. Cornelius Vanderbilt was quoted in the epic book The First Tycoon as saying (emphasis mine):
I’ll tell you what’s the matter – people undertake to do about four times as much business as they can legitimately undertake.… There are a great many worthless railroads started in this country without any means to carry them through. Respectable banking houses in New York, so called, make themselves agents for sale of the bonds of the railroads in question and give a kind of moral guarantee of their genuineness. The bonds soon reach Europe, and the markets of their commercial centres, from the character of the endorsers, are soon flooded with them.… When I have some money I buy railroad stock or something else, but I don’t buy on credit. I pay for what I get. People who live too much on credit generally get brought up with a round turn in the long run. The Wall Street averages ruin many a man there, and is like faro.”
In the wake of Gould’s shenanigans, President Grant came to New York to assess the damage; and eventually his Secretary of the Treasury decided to buy $30 million of bonds in a less-clumsy precursor to Federal Reserve open-market operations, trying to inject some liquidity back into the markets. This was done largely as a consequence of a conversation with Vanderbilt, who offered to put up $10 million of his own, a vast sum at the time.
But the damage was done. The problem of liquidity was created by too much debt, as Vanderbilt noted. That debt inflated assets, and when those assets fell in price, so did the net worth of the borrowers. Far too much debt had to be worked off, and the asset price crash precipitated a rather deep depression, leaving in its wake far greater devastation than the recent Great Recession did. It took many years for the deleveraging process to work out. Sound familiar?
The Panic of 1873 started one of the longest depressions in American history – sixty-five straight months of economic contraction. In the next year, half of America’s iron mills would close; by 1876, more than half of the railroads would go bankrupt. Unemployment, hunger, and homelessness blighted the nation. “In the winter of 1873–74, cities from Boston to Chicago witnessed massive demonstrations demanding that authorities ease the economic crisis,” Eric Foner writes. The irony is that the fall was far more severe because of the rapid rise of the previous decade. The expanding, increasingly efficient railroad network had created a truly national market. The fates of farmers, workers, merchants, and industrialists across the landscape were tied together as never before. New York had cast its financial net across the country, which meant that credit flowed to remote regions far more easily than before – but also that financial panics affected the entire nation. As Vanderbilt pointed out, railroad overbuilding was an underlying economic problem, and it was exacerbated by Wall Street’s craze for railway securities. When the bubble burst, the consequences were felt across the country with devastating suddenness and severity.” (From The First Tycoon)
Can you hear the rhyme? This almost eerily echoes our own time and the interconnectedness of international markets. The growth in global markets has been funded by debt, fueled by quantitative easing. Yet, for the moment, the markets believe that central banks can control any panic or crisis. Somehow this time is different. Our central bankers have come up with all sorts of new tools and techniques, so there is nothing but upside – rainbows and unicorns.
I cannot recommend highly enough The First Tycoon, the book on Cornelius Vanderbilt by T. J. Stiles. It is incredibly well-written and researched and won a Pulitzer Prize as well as a National Book Award. My only real problem with the book is that there was so much fascinating detail and useful trivia that I could not skim through but had to slow down and absorb it all! While Vanderbilt is the central character, the book is far more than a biography. It is a compelling history of the rise of steam engines and railroads, and just as important, the beginning of the invention of the idea that a corporation is something separate from its shareholders. This was a truly radical concept and took decades to play out. Insider trading was legal and was done all the time. It was a true laissez-faire, buyer-beware market. Self-dealing, price collusion, and other corporate practices that we would consider repugnant today were standard fare.
But you have to understand that there was no precedent for the circumstances of autumn, 1873. The country was embroiled in a great and contentious conversation over what money and banking and corporations and business should be, all of this happening as new technologies turned millennia-old social processes on their heads. Railroads would have been impossible without corporations, and railroads vastly emancipated and enriched the West (and the rest of the world, wherever they went). Even in an era of price collusion, railroads brought the cost of shipping products down dramatically. The McCormick reaper greatly enhanced the productivity of farms just as a market for their produce appeared by means of cheaper transportation to growing Eastern seaboard cities and Europe. Agriculture went from producing 53% of total national commodity output to less than 33% as manufacturing became dominant, spurring mass labor movement from the country to the cities with their factories. Meanwhile a new wave of immigrants poured into the US.
The new technologies made everything less expensive and more abundant. Steam engines went from small and inefficient to massive and powerful, capable of driving huge ships and trains with less fuel cost. Transportation went from being a small part of the economy to being the very heart, employing hundreds of thousands. The period of time from 1870 to 1900 was one of general price deflation of almost everything. But in general, it was the good deflation that comes from increased productivity and lower prices – once the asset deflation of the Panic of 1873 was worked out.
Businesses, professionals, government, and society in general were all having to learn new rules for everything, and then scrapping the new rules for even newer rules. There was no playbook, no organizing principle for building a new society. They had to create entirely new institutions from whole cloth. They were literally inventing modern society from the ground up – a task somewhat akin to building an airplane while it is trying to taxi down the runway.
And that’s the point we need to fully understand. They were making it up as they went along. I should note that the crises of that era were not just financial. Government was constantly running behind the rather messy process of transformation, trying to contain the damage. Like generals fighting the last war, the bureaucrats were always trying to make sure the last crisis or bad policy would not be repeated. All sorts of new laws needed to be enacted in order to level the playing field for average citizens. Farmers felt put upon by the railroads and the vast wealth of the railroad magnates (even as freight prices generally fell). Price fixing among monopolistic cartels was the norm. Unions were brutally suppressed time and time again and in turn were often violent. Politicians were openly bought and sold. The journalists of those times had all the gentility of the current denizens of the internet, which is to say, generally none.
Income inequality? When Vanderbilt died, he was worth an estimated $100 million (multiple trillions of dollars in current buying power) and was the richest man up to that point. He was just the first of a number of contemporaries who would go on to amass even greater fortunes. Wealth disparity from top to bottom was far worse than it is today, and the poverty at the bottom was devastating. There was no social safety net of any kind.
And let’s not kid ourselves: much of the social and financial mess of the 19th century is still with us today. In fact, if you read deeply enough, you find that we have been trying to solve these large societal problems for hundreds of years. Somehow each generation thinks they have finally got it figured out.
Reading the commentary from the papers of that time, you are struck by the level of optimism that the leaders of society expressed – they certainly believed they had figured it all out. Nothing but upside. Until, of course, the next crisis ensued.
We live in an era that does not repeat the latter part of the 19th century – things have changed – but there is a rhythm and a rhyme that seem hauntingly familiar. There is the enduring belief that this time is different. Each unfolding generation feels that it will solve the problems of the previous generations, even as each older generation in turn despairs of the wisdom and probity of its youth. We play Minsky’s old tune, “Stability Leads to Instability,” over and over again. You would think we could figure out how this song ends and come up with a different, less tumultuous tune.
And our “generals” do indeed go on trying to fix the problems of the last war, missing the entirely new problems that are developing. Until a crisis steers our common vehicle into the ditch, we cling to the illusion of control. We look at the rampant corruption of the Gilded Age and believe we have made progress. And we have: we have progressed to new levels of problems, some of which are altogether unappreciated and certain to produce their own unexpected and unintended consequences and eventual crises.
The Link Among All Crises
But we have not dealt with the primary cause of nearly all financial crises throughout modern history and throughout the world: too much of the wrong kind of debt – debt which is nonproductive. Paul Krugman, the most visible spokesman for those who think it is old-fashioned and foolish to worry about the debt, recently wrote:
On the Chicken Little aspect: It’s actually awesome, in a way, to realize how long cries of looming disaster have filled our airwaves and op-ed pages. For example, I just reread an op-ed article by Alan Greenspan in The Wall Street Journal, warning that our budget deficit will lead to soaring inflation and interest rates. What about the reality of low inflation and low rates? That, he declares in the article, is “regrettable, because it is fostering a sense of complacency.”
It’s curious how readily people who normally revere the wisdom of markets declare the markets all wrong when they fail to panic the way they’re supposed to. But the really striking thing at this point is the date: Mr. Greenspan’s article was published in June 2010, almost three and a half years ago – and both inflation and interest rates remain low.
And he is right, up to a point: too much debt is not a crisis today. Too much debt is never a crisis, right up until the moment it becomes a crisis. Too much debt was not widely recognized as an issue in the US in 2006 or in Europe in 2010, but then – boom! – it became an issue. And throughout the developed world and China, today’s levels of debt, an ever-increasing amount of which is unproductive, are staggeringly high.
The currently fashionable way to deal with too much debt is to punish savers and enrich the already rich, prolonging a situation in which even more debt can be accumulated. Markets believe in the effectiveness of central bank actions precisely because they want to, not because there is any well-established basis for that belief. Yes, we have dealt with some of the problems that gave rise to the last crisis, but we have still not dealt with the underlying, fundamental problem of too much nonproductive debt. At some point, some nasty cousin of subprime debt will come along to prick our bubble. And because debt levels are now even higher than they were in 2007 and there is less scope for the Federal Reserve to intervene with interest rates, the next crisis will not be a repeat of the Great Recession but its own calamitous variant. Which will bring yet more monetary and fiscal intervention, which will produce its own unintended consequences.
And speaking of unintended consequences, let us now turn to Japan.
Japan: The World’s Largest Hedge Fund
In a (reputedly) passionately contested 5 to 4 vote, the board of governors of the Bank of Japan voted essentially to become the world’s largest hedge fund. Not only did they raise the level of quantitative easing by over 15%, to the equivalent of $720 billion a year, they are aggressively allocating and increasing portions of that money to Japanese equity markets and REITs. In a (supposedly) uncoordinated but almost simultaneous announcement, the $1 trillion+ government pension fund announced a move to sell Japanese bonds in size and increase their equity holdings in Japanese and foreign stocks by 20%, divided equally between Japanese and foreign markets. This is the equivalent of $200 billion being injected into global equity markets from one pension fund alone. We can expect that nearly every other Japanese pension fund will follow suit, meaning that potentially hundreds of billions of dollars will be thrust into global equity markets.
Bank of Japan Governor Kuroda said that the move was necessary to achieve their inflation target of 2%. Core Japanese inflation fell to 1.2% last month (after adjusting for the sales tax increase) and has been falling for the last six months. He has a target of 5% nominal GDP growth, by which we assume he means 2% inflation and 3% real GDP growth. The fact that nominal growth has been almost literally zero for the last 20+ years doesn’t seem to impact his optimistic target.
In his comments after the announcement, Kuroda-san said, “[However,] it is important for the BOJ to strongly commit to achieving its price target to get its price target firmly embedded in people’s mindset…. [Thus] we have pledged
