Does the Past Determine Our Economic Future?
For more than 200 years, the U.S. economy has been on an upward trajectory despite numerous setbacks along the way. The virtual nonstop output of goods and services has been one of the great success stories of Western civilization.
People from Europe and other continents came to America even before the republic was created in 1788 and began to build one the most dynamic economies in human history. Probably the greatest challenge the American people faced occurred 160 years ago when the union was nearly torn apart by the Civil War. The war caused, according to new estimates, more than 800,000 deaths on both sides and untold destruction and damage to factories, farms, and infrastructure throughout the young nation. The regional rivalry culminated in the abolition of slavery, which many historians cite as the cause of the South’s desire to secede from the union, but other historians and economists assert the federal government’s tariff policies triggered the South’s desire to leave the union that they voluntarily consented to join in the previous century.1
Prior to the Civil War, the United States and Britain squared off in the War of 1812, which nearly derailed the new republic’s quest for continued independence. Nevertheless, war inevitably brings economic pain and dislocations. The economic fallout from the War of 1812 can be traced to the battle between Alexander Hamilton, America’s first treasury secretary, and Thomas Jefferson, his political and philosophical rival, over their respective visions for America’s future.
Hamilton’s vision was nothing less than centralization of economic power in the federal government. He favored tariffs and other taxes to generate revenue for the new republic, and paying off the Revolutionary War debt the states and the Continental Congress acquired. Hamilton also wanted the federal government to charter a national bank and create a national currency. Jefferson, on the other hand, opposed concentration of economic power in the federal government and was skeptical about banks, which he believed “encouraged speculation.”2
Despite Jefferson’s concerns and opposition, Congress soon adopted many of Hamilton’s recommendations including the establishment, in 1791, of the Bank of United States and granting it a 20-year charter. One of Jefferson’s main objections to the bank was his belief that the Constitution did not authorize the Congress to create one. Nevertheless, Hamilton and his supporters viewed the bank as a necessary institution to help grow the economy and also would be instrumental in eventually making United States a global economic power.3
The bank’s 20-year charter expired prior to the War of 1812, and the Second Bank of the United States was charted in April 1816. President James Madison signed the charter even though he had been a political ally of Jefferson. Bank began operations a year later and was similar in structure to the First Bank. The second bank held federal deposits and issued debt, supervised state chartered banks, and accepted deposits to make loans to individuals and businesses within its 25-bank network.4
The Panic of 1819
Soon after the bank began its operations in 1817, the U.S. economy experienced its first depression, the Panic of 1819. The genesis of America’s first (great) depression, according to a synopsis of what is considered a definitive account of the panic, Murray Rothbard’s The Panic of 1819, the War of 1812 led to a “boom” financed by the creation of paper money by state banks to finance the conflict. At the time, banks were required to “back” their notes with specie (typically gold and silver), and when the supply of notes increased markedly, many banks suspended redeeming their notes, beginning in 1814. Without specie redemption, the number of banks proliferated, primarily outside of New England, as did the amount of paper money in the economy. The inevitable price inflation and boom followed.5
As Rothbard explains, the Panic of 1819 mystified most observers at the time who could not understand why the so-called good times lead to a huge bust. The boom had a huge impact on trade with Europe. Although exports increased substantially, imports increased more rapidly. In addition,
The rise in export values and the monetary and credit expansion led to a boom in urban and rural real estate prices, speculation in the purchase of public lands, and rapidly growing indebtedness by farmers for projected improvements. The prosperity of the farmers led to prosperity in the cities and towns—so largely devoted were they to import and export trade with the farm population.6
As the boom unfolded, a new institution was created in 1817, the New York Stock Exchange. Instead of trading on the curbs of Wall Street, traders now moved indoors. This period also saw the beginning of investment banking. Needless to say, although the foundation of America’s financial system was being shaped, the banking sector spearheaded by the Second Bank of United States and its expansionary policies sowed the seeds of the boom-bust cycle, which was baffling to policy makers and the general population. As confidence in banks declined because they issued more notes than specie on deposit, the public began to redeem as many of their notes as possible, causing the banks to be in a more precarious financial situation. The Second Bank of United States then began the painful contraction of notes in circulation in the summer of 1818. As supply of money declined and liquidity became a problem for many sectors of the economy, the Panic of 1819 soon followed. The deflation that occurred was is in effect the necessary period of adjustment to reduce the inflated prices during the unsustainable boom after the War of 1812.7
Although the economy began to recover in 1821, urban unemployment had increased substantially as manufacturing workers, most of whom were self-employed, bore the brunt of the depression. Individuals who had borrowed heavily to speculate in land and other ventures caused bankruptcies to skyrocket.8 In short, the Panic of 1819––the first recognizable boom and bust cycle—had all the characteristics of future business cycles in the 19th century. As Rothbard explains,
The period also saw much of the typical characteristics of later financial panics: expansion of bank notes; followed by a specie drain from the banks both abroad and at home; and finally a crisis with a contraction of bank notes, runs on banks, and bank failures. A corollary to the contraction of loans and bank runs was the scramble for a cash position and rapid rise in interest rates during the panic.9
Reoccurring Panics
The Panic of 1819 thus provided a glimpse of what was to come during the remainder of the 19th century. Major banking panics occurred in 1837, 1873, 1884, and 1893.10 As the 19th century unfolded, America was transformed from an agricultural, rural based society into an urban, industrialized economy by the beginning of the 20th century. According to David Erickson, “This enormous social change and the increasing complexity of economy arguably exacerbated the consequences of the financial panics and other economic disruptions in later periods.”11
Rothbard, however, paints a more optimistic picture of the second half of the 19th century. He points out that the U.S. economy was working on all cylinders as production and real output per capita increased markedly from 1879 to 1896. The year 1879 saw a return to the gold standard, which was suspended during the Civil War. Rothbard points out that the gold standard gave more stability to the financial system and banking sector. He also questions whether there was a great depression from 1873 to 1879, which orthodox economic historians have asserted was a period of depressed economic conditions.12 Although prices fell during this period, production increased confounding economists who believe that price deflation is associated with depressed economic conditions.
In the meantime, the National Banking Act of 1863, 1864, and 1865 created a quasi-central bank centered on Wall Street, which allowed the banking system to “inflate the supply of notes and deposits in a coordinated manner.” Nevertheless, as the economy was growing up especially in the heartland, St. Louis and Chicago became important banking centers, and the major complaint of the big Wall Street banks was that there was a need for the money supply to be more “elastic,” which is a euphemism for the ability to expand money and credit.13
The Panic of 1893 ignited a populist movement headed by William Jennings Bryan, who became the Democratic Party’s nominee for president in 1896. Bryan’s anti-gold convention speech ignited a political firestorm and led to realignment of American politics. The pro gold Democrats threw their support behind the Republican presidential nominee William McKinley who was elected with strong backing from the Wall Street banks. The Wall Street bankers then pressed for financial “reforms,” namely, an “elastic” gold-based monetary system, which would allow the banks to inflate in a concerted manner without igniting a financial panic.14
The Gold Standard Act was passed in March 1900 and put the United States on a single gold standard, with silver fulfilling a minor role in the monetary system. The debate, therefore, of having a bimetallic monetary system was basically laid to rest. This contentious issue sparked passionate political conflicts throughout most of the 19th century, but as gold won out for the time being, the unfolding of America’s financial and banking system continued.
Panic of 1907
Before the end of the first decade of the 20th century, another panic gripped the nation. According to Moen and Tallman, the role of trust companies, primarily located in New York City, is considered the focal point of the panic. As state-charted institutions, trust companies accepted deposits in competition with banks and kept only around 5 percent reserves relative to their deposits while national banks maintained a 25 percent reserve ratio.15 In other words, trust companies were susceptible to runs if their customers lost confidence in them. In addition, trust companies provided loans to New York Stock Exchange brokers, which typically had to be repaid at the end of the day.16
In October 1907, two speculators failed in their attempt (“cornering the market”) to make a killing in a mining stock, United Copper. As a word of their failure made the rounds on Wall Street, depositors began to run on the banks associated with their speculation. A few days later, the New York Clearing House calmed the situation and the bank run was halted, but not before a run began on the trust companies, especially Knickerbocker Trust, triggering a major financial crisis in the New York City. Initially, J.P. Morgan decided not to aid the trust companies but eventually changed his mind. Nevertheless, depositors continued to withdraw funds from the trust companies and interest rates spiked as there was a scramble for short-term funds, and only after the New York Clearing House injected liquidity into the financial system did the panic subside.17
The economic fallout from the panic caused industrial production to fall by 17 percent in 1908 and real GNP contracted by 12 percent. The good news was that the economy recovered in a little over a year.18
In their conclusion about the Panic of 1907, Moen and Tallman observe:
The panic of 1907 took place over 100 years ago, before the establishment of the Federal Reserve System, the Federal Deposit Insurance Corporation, or the Securities and Exchange Commission––institutions designed to bring stability to banking and financial markets. Before these institutions, the National Banking Act provided the regulatory structure of guarding the day-to-day behavior of banks, particularly the largest and most interconnected ones. During the panic, however, the acts provided little guidance to bankers coping with large-scale withdrawal of deposits.19
The Panic of 1907 was the impetus to create a central bank that would be in the final analysis a lender of last resort to bail out shaky banks.20 In order to get the general public to support a government-sponsored central bank when distrust of Wall Street and banks was widespread, the financial elites came up with an elaborate plan to sell the public the idea of having a bank that would “stabilize” the financial sector. What emerged from this effort eventually turned out to be the Federal Reserve.
Creation of the Federal Reserve
At a secret meeting (November 1910) at the Jekyll Island Club, off the coast of Georgia, the blueprint for the Federal Reserve was ironed out by six men, a powerful Republican senator, Nelson A. Aldrich from Rhode Island, representatives from major Wall Street banks, and a member of the recently created National Monetary Commission, whose task was to pave the way for the public and the banking community to support a central bank.21
The creation of the Federal Reserve essentially capped the end of the Progressive Movement in America, which supposedly was a period of “reform” to break up monopolies with antitrust legislation, expand democracy with the direct election of senators (17th Amendment), and put a check on corporate power with the creation of such agencies as the Federal Trade Commission (FTC) and the Food and Drug Administration (FDA) among others. The reality, according to some historians and other social scientists, is that the progressive movement was in effect a means to expand the economic power of certain business interests at the expense of the public. Inasmuch as cartels are unsustainable in the free market, business interests sought the power of government to achieve their goals.22
After a three-year campaign to gather both public and congressional support, President Woodrow Wilson signed the Federal Reserve Act on December 23, 1913. America’s bankers finally got a central bank whose mission was to be a lender of last resort, smooth out the business cycle, and maintain the purchasing power of the dollar. All worthy goals to be sure. But as Rothbard concludes after extensive research in the history of the Fed’s creation,
The financial elites of this country, notably the Morgan, Rockefeller, and Kuhn, Loeb interests, were responsible for putting through the Federal Reserve System, as a governmentally created and sanctioned cartel device to enable the nation’s banks to inflate the money supply in a coordinated fashion, without suffering a quick retribution from depositors or noteholders demanding cash.23
The Federal Reserve opened its doors in 1914. Despite having substantial tools at its disposal to achieve its three initial goals—maintain the purchasing power of the dollar, smooth out the business cycle and be a lender of resort for the banking system—the business cycle has not been “smoothed out,” the dollar’s purchasing power has fallen by 95 percent since 1914, and the financial system has been bailed out on numerous occasions, most notably during the Great Recession of 2007–2009. In short, why has the business cycle not been banished or at least tamed, as the proponents of central banking have asserted it would be if the United States adopted an institution with broad regulatory and other powers to shore up the banking system?
Recurring Cycles
The same year the Federal Reserve began operations (1914), the Great War—now known as World War I—erupted in Europe. The belligerent nations resorted to higher taxes and borrowing and printing money to pay for the armaments each side needed to conduct the war. President Woodrow Wilson ran for the 1916 election with a promise to keep Americans out of the war. After he was reelected and a month after his inauguration, Wilson declared war (April 1917) on Germany and her allies.24
The U.S. economy was booming during the Great War, supplying foodstuffs and other materials to the European powers. When the United States entered the war, taxes were raised substantially, especially on upper income earners who saw their marginal tax rate reach 77 percent. The federal government also borrowed substantial sums from the public to fight the war. Buying liberty bonds was considered an essential patriot act. In addition, the Federal Reserve provided considerable liquidity to the banking system. The U.S. economy was in the boom phase of the business cycle. Even after hostilities ended in 1918, many analysts predicted a major correction that did not materialize. Instead, the economy was in full throttle and price inflation was accelerating. However, when it comes to the business cycle, what goes up must come down.
The Federal Reserve’s easy money policies generated exhilaration in virtually all sectors of the economy.25 From raw materials to autos and other consumer goods to farm products, rising prices created substantial profits for companies and the farming community. Soon, however, the boom turned to bust beginning in early 1920. The unemployment rate zoomed from 4 percent to nearly 12 percent and the economy contracted 17 percent. With President Wilson debilitated by a stroke in his last year in office, the federal government did not try to “stimulate” the economy to bring down unemployment and boost the output of goods and services.
The election of Warren G. Harding (1920) and his response to the unfolding depression, according to James Grant, was the last time the federal government did not intervene in economy with fiscal stimulus to boost the economy. In addition, instead of lowering interest rates to stimulate production, the Federal Reserve raised rates.26 The 18-month depression, as painful as it was, was the last laissez-faire response to the bust phase of the business cycle. Both wages and prices fell, and sure enough, when prices became attractive for employers and investors, they began to spend and invest to end the correction that was inevitable after the unsustainable boom generated by the easy money policies of prior years.
Interestingly, the Federal Reserve’s history page makes no mention of the 1920–1921 depression, which is quite surprising since the portal provides substantial information about previous and subsequent boom-bust cycles. Could it be that one reason the Federal Reserve is reluctant to present information about the “forgotten depression” is that it does not fit the narrative that a laissez-faire approach to economic downturns is the best way to end the bust phase of the business cycle?27
Nevertheless, the U.S. economy recovered during the 1920s, a period dubbed the Roaring Twenties, as the introduction of new products and technologies such as radio and other home appliances stimulated both production and consumption. Auto sales reached a feverish pitch as the mass production of motor vehicles made them more affordable to many households. However, the Federal Reserve was not “hands off” during the decade. It injected substantial liquidity in the banking system that created a boom in both stocks and real estate throughout the decade.28 The real estate bubble burst in 1926 and the famous stock market peak of September 1929, when the Dow Jones Industrial Average reached 381.22, was followed by a nearly 90 percent decline over the next several years to 41.22 in July 1932 (see Figure 4.1). After the 1932 bottom, stock market roared ahead until it reached another peak in 1937 (see Figure 4.2).
Although the 1930s has been recognized as the Great Depression conventional dating of booms and busts recognize the early period of the depression, as a major downturn was followed by a “boom” and then another downturn in the middle of the decade, and then an economic expansion until the end of World War II as measured by industrial production (see Figure 4.3). Unemployment was still in double digits throughout the decade. At the eve of World War II, the unemployment rate was between 10 and 15 percent, hardly a period of prosperity, but then declined as the postwar boom kicked in as pent-up demand helped ignite the prosperity of the 1950s and 1960s, which was interrupted by several recessions (Figure 4.4).
Figure 4.1 The stock market crash, 1929–1932
Chart courtesy of stockcharts.com
Figure 4.2 The stock market boom, 1932–1937
Chart courtesy of stockcharts.com
Figure 4.3 Industrial production and the boom-bust cycle
Source: Board of Governors of the Federal Reserve System (U.S.), Industrial production: Total index [INDPRO], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/INDPRO, March 10, 2021.
Clearly, in the U.S. economy, there has been a major uptrend since the “washout” of the 1929–1932 stock market decline and Great Contraction. For all intents and purposes, the stock market has been on a long-term uptrend since the end of World War II. Nevertheless, there have been multiyear secular booms (1949–1966 and 1982–2000) and multiyear periods of secular stagnation (1966–1982 and 2000–2014, Figure 4.5). Within the long-term trends, there were “cyclical” market booms and busts when severe declines were followed by sharp rallies. Even the record one-day decline (22.6 percent) in October 1987 is a “blip” in the long-term bull market that began in August 1982. Currently, it appears we are in another secular bull market. How long it will last remains to be seen. If history is any guide, it could last until the end of the 2020s. However, it would not be surprising if the stock market has several sharp cyclical declines from now until the end of the decade, which occurs during every secular bull market.
Figure 4.4 Unemployment rate since World War II
Source: U.S. Bureau of Labor Statistics, Unemployment rate [UNRATE], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/UNRATE, March 10, 2021.
Annual real GDP growth has been positive except for the recessions during the past 75 years. The boom phase of the business cycle occurs as “natural” economic forces kick in. In addition, rather than allowing the recovery to occur on a sound footing, real savings, and market interest rates, the federal government “primes the pump” with deficit spending and the Federal Reserve opens the money spigot to give the economy additional “oomph” to boost the economy. These have been the twin policies since the Great Depression.
Prior to the millennium, on many occasions, the economy grew at a 5 percent or more for several quarters during the boom phase of the cycle. Since 2000, an interesting cyclical phenomenon has occurred. There has not been one quarter of real GDP exceeding a 5 percent annual growth rate. There have been many explanations put forward as to why the U.S. economy is mired in relatively tepid economic growth since the end of the dot-com bubble. One that is consistent with the Austrian school business cycle theory, namely, that after the dot-com bubble burst, the Federal Reserve lowered interest rates to nearly 1 percent in the early 2000s, then to nearly zero again after the Great Recession (2007–2009), and most recently during the 2020 pandemic with the injections of liquidity. These ultra-easy money episodes primarily boosted asset values. The easy money episodes of the past two decades, instead of “stimulating” the economy’s output of goods and services have impeded the “price discovery” necessary to create a robust economy, and that is why real savings, not money printing, are the key to sustainable prosperity.29
Figure 4.5 Long-term market cycles
Chart courtesy of stockcharts.com
Does a 100-Year Super Cycle Determine Our Future?
The U.S. economy has had several major panics, depressions, and economic contractions since the birth of the country. Is there a pattern to all these major downturns in the economy? For example, the Panic of 1819 was America’s first Great Depression. Hundred years later, roughly speaking, the forgotten depression of 1920 began. Coincidence? The Panic of 1873, which ended the speculation after the Civil War in which there was enormous overinvestment in the railroads, preceded the first oil crisis in 1973 by a 100 years and ushered in the deepest recession at that time since the Great Depression.
The Panic of 1907, which provided the impetus for the creation of the Federal Reserve a few years later, occurred 100 years before the great recession of 2007–2009. The forgotten the depression of 1920–1921 occurred 100 years before the pandemic of 2020. In 2020, the stock market had its one-month decline in February to March and the market rebounded sharply after the Federal Reserve flooded the financial system with new money.
The next 100-year super cycle date, the stock market crash that began in the fall of 1929, implies that a major financial event could occur around 2029. Although there is no theoretical foundation for these 100-year cycles, they are nevertheless real. Whether a crash in 2029 occurs remains to be seen, but if a crash does happen at the end of this decade, then economists, financial historians, and others will have a fertile area for research to explain how major financial cycles have occurred almost like clockwork every 100 years.
Irrational Exuberance: Avoidable or Inevitable?
In their classic Manias, Panics, and Crashes, Robert Z. Aliber and Charles P. Kindleberger identify 10 bubbles beginning with the Dutch tulip mania in 1636 and ending with the real estate bubble in United States and other European nations. In between, the authors cite the U.S. stock market bubble of the late 1920s and the dot-com bubble in the late 1990s as classic bubble episodes.30 The authors point out that, “Manias—especially macro manias—are associated with economic euphoria; business firms become increasingly upbeat and investment spending surges because credit is plentiful31 (emphasis added). In Japan, Real estate prices and stock prices headed to the stratosphere as bankers made credit easily available. With an enormous amount of liquidity in their country, “the Japanese purchased 10,000 items of French art.”32
The authors acknowledge what previous analysts have identified as the cause of bubbles and manias. “Speculative manias gather speed through expansion of credit. Most increases in the supply of credit did not lead to a mania—but nearly every mania has been associated with rapid growth in the supply of credit to a particular group of borrowers. In the last 100 years, the increases and supplies of credit have been provided in part by the banks, in part by the development of new financial instruments and in part by cross-border investment inflows.”33
More often than not “frauds and swindles” have been occurring with get-rich-quick schemes such as the infamous Charles Ponzi, who in the 1920s promised investors 45 percent interest, and for 18 months, he kept his “Ponzi” game going until there was no money there for depositors to withdraw funds. Most recently, Bernie Madoff’s Ponzi scheme, estimated to be as high as $64 billion, collapsed in December 2008 just as the real estate bubble was bursting.34
These two notorious episodes reveal how slick financial salesmen promising extraordinary returns can dupe investors as in the case of Charles Ponzi or in the case of Bernie Madoff who promised investors relatively risk-free steady rates of returns. In both instances, investors obviously did not do their due diligence, relying instead on the trustworthiness and credibility of both Ponzi and Madoff. In short, investors who got in late lost most or all of their money.
But what about “honest” bubbles that create “irrational exuberance” in the financial world? The term became popular after Alan Greenspan delivered a speech in December 1996 when he was chairman of the Federal Reserve, indicating that the stock market may have reached frosty levels. Yale economics professor Robert Shiller in his best-selling book, Irrational Exuberance, published at the height of the dot-com bubble in 2000, pointed out that the economy suffered a form of psychological dysfunction, which causes investors to throw caution to the wind and thus invest unwisely to obtain abnormal profits.
I define speculative bubble as a situation in which news of price increases spurs investor enthusiasm, which spreads by psychological contagion from person-to-person, and, in the process, amplify stories that might justify the price increase and brings in a larger and larger class investors, who, despite doubts about the real value of the investment, are drawn to it partly through envy of others’ successes and partly through a gambler’s excitement.35
Financial analyst Frank Shostak takes issue with Shiller’s diagnosis of bubbles and points out that he only describes a bubble’s characteristics without focusing in on the underlying cause(s) of what objective factors precipitate a bubble in the first place. According to Shostak, a “monetary balloon” causes ballooning asset prices, that is, an expansion of the money supply, which he asserts is similar to “counterfeiter” that diverts resources from the creation of a real wealth to nonproductive activities.36 For Shostak then, psychology is irrelevant in understanding bubbles; an analyst should focus on the growth of the money supply which sets into motion the unsustainable booms in various sectors of the economy, typically the stock market and real estate. In addition, he points out that as the rate of growth of the money supply declines, the bursting of the bubble inevitably follows.
As long as the money supply keeps growing, the bubble can inflate, which according to Fleckenstein and Sheehan gets a boost in part by the financial networks reporting of the substantial run-up in various stock sectors. The financial networks thus play a role in igniting additional investor interest in high-flying stocks. So as the bubble unfolds, it tends to feed on itself.37
At the end of 2020, there is a difference of opinion among financial analyst whether the current stock market recovery from the pandemic low of March 2020 is another of irrational exuberance.
Former Reagan’s budget official David Stockman has asserted that the stock market is out of touch with reality. Former CNBC anchor Ron Insana makes the case that many of the same factors that were evident in previous bubbles are obvious in 2020, such as “extreme day-trading, and the unprecedented gains in mega stocks coupled with rapid speculation in so-called penny stocks.”38