The Great Deformation (28 page)

The conference had the good fortune that its presiding officer was Secretary of State Cordell Hull. A former Democratic senator from Tennessee and a splendid statesman, Hull had been a staunch advocate of free trade, the gold standard, and an open international economy.

Most of the assembled financial officials, including Hull, recognized that restoration of some semblance of exchange-rate stability was the key to the rest of the conference agenda, especially to rolling back the protectionist trade barriers which were rapidly choking off world trade. The latter had sprung up everywhere after Smoot-Hawley and were being compounded by beggar-thy-neighbor currency manipulation after the sterling-based gold exchange system broke down.

After long and arduous negotiations, the framework for such a monetary stabilization agreement was reached soon after Moley arrived in London. The US delegation, Great Britain, and the French-led gold bloc nations had all managed to find common ground. While Moley had been a strident voice of nationalistic autarky in the Roosevelt inner circle, even he was persuaded by Hull and the British to endorse the tentative internationalist agreement.

The heart of the plan was repegging the dollar to pound exchange rate in a narrow band about 20 percent below the old parity (i.e., at about $4.00 versus $4.86 per pound sterling). From that pivot point, the French franc and other major currencies would be fixed to the dollar.

The significance of this breakthrough cannot be gainsaid. All sides recognized that floating currencies would poison the international trading system, encourage destructive currency speculation, and fuel violent movements of “hot money” among financial centers. The latter would continuously destabilize both national money markets and confidence in the international trading system as a whole.

In one of the great misfortunes of history, however, FDR was literally incommunicado during the hours when a global consensus to reboot the international financial system briefly flickered. Alone on Astor's luxurious yacht, the
Nourmahal,
the president had the advice of only his wealthy dilettante chum Vincent Astor and Louis Howe, his butler and glorified White House “secretary.”

When Moley finally found a navy ship to track down the
Nourmahal
and deliver a radio message outlining the nascent London agreement, Roosevelt, Howe, Astor, and perhaps also the yacht's captain, as it were, gathered around a kerosene lamp on the deck. There they scribbled out a handwritten response and turned it over to the navy for radio dispatch back to London.

Roosevelt's message was undoubtedly among the most intemperate, incoherent, and bombastic communiqués ever publicly issued by a US president. It not only stunned the assembled world leaders gathered in London and killed the monetary stabilization agreement on the spot, but it also locked in a destructive worldwide régime of economic nationalism that eventually led to war.

High tariffs and trade subsidies, state-dominated recovery and rearmament programs, and manipulated fiat currencies became universal after the London conference failed. In the months which followed, Sweden, Holland, and France were driven off the gold standard, leaving international financial markets demoralized and chaotic.

At the end of the day, it was only the outbreak of war in 1939–1940 which pulled the world out of the rut of economic nationalism and stagnation to which FDR's quixotic action had condemned it. It also meant that the domestic economy had now been cut off from its vital export markets, condemning the nation to a halting recovery and to continuous and mostly ineffectual New Deal doctoring that succeeded primarily in planting the seeds of welfare state expansion and crony capitalism.

Roosevelt's deplorable action from the deck of the
Nourmahal
tends to be dismissed by historians as a forgivable bad hair day early in the reign of the economic-savior president. In fact, it was the very opposite: FDR's single-handed sabotage of the London conference was one bookend of a thirty-eight-year epoch. The other end was bounded by Richard Nixon's equally impudent destruction of Bretton Woods in August 1971.

In each case the modus operandi was the same. Both Roosevelt and Nixon were aggressive politicians who lacked any enduring convictions about economic policy. Neither had any compunction at all, however, about using the taxing, spending, regulatory, and money-printing powers of the state to achieve their domestic political and electoral objectives. In the great scheme of modern financial history FDR and Tricky Dick were peas in a statist pod.

THE GREAT WAR AND THE ROARING TWENTIES:

CRADLE OF THE GREAT DEPRESSION

FDR's mortal blow to international monetary stability and world trade is the pattern through which the New Deal was shaped. Once Roosevelt went for domestic autarky, the New Deal was destined to be a one-armed bandit. It capriciously pushed, pulled, and reshuffled the supply side of the domestic economy, but it could not regenerate the external markets upon which the post-1914 American prosperity had vitally depended.

Herbert Hoover had been correct: the US depression was rooted in the collapse of global trade, not in some flaw of capitalism or any of the other uniquely domestic afflictions on which the New Deal programs were predicated. Indeed, the American economy had been thoroughly internationalized after August 1914 and had grown by leaps and bounds as a great export machine and prodigious banker to the world.

While it lasted, the export boom of 1914–1929 generated strong gains in
domestic incomes, which in turn fueled the postwar rise of new durables industries like autos and home appliances. The tremendous expansion of exports and durables output also triggered the greatest capital spending boom in history. Auto production capacity, for example, rose from under 2 million units in 1920 to nearly 6 million by 1929, while whole new industries like radios and washing machines were born almost overnight.

The fact that the American economy had become supersized for continuous expansion of exports and durables, however, was its Achilles heel. In the event of a slowdown in demand for these core manufactures, rapid capacity expansion would stop and the capital goods industries would plummet. Likewise, consumer goods factories would be saddled with vast idle capacity if the bubble-fueled demand of the late 1920s faltered. Then a general spiral of falling incomes, profits, employment, and consumption would ensue.

When the great stock market bubble reached its apex in September 1929, the handwriting was already on the wall. The temporary “wealth effect” of soaring stock prices, along with the huge expansion of consumer installment loans and home mortgage finance, had fostered booming sales of autos, appliances, radios, and other consumer durables. All of this came to an abrupt halt when stock prices came tumbling back to earth.

Yet the financial bubble was not just domestic. It began way back in 1914 when the “guns of August” suddenly transformed the United States into the arsenal and granary of the world and an instant, giant global creditor. This was not a natural or sustainable route to rapid growth but it powered the US economy to a scale and level of prosperity that was palpable.

After the deep but brief post-armistice slump (1920–1921), America resumed its role as a giant creditor and exporter. By contrast, the rest of the world struggled to restart domestic economies and regain financial and monetary normalcy after desperate wartime sprees of government borrowing and currency inflation.

A crucial element of the postwar stabilization process, especially in central Europe and among commodity-producing nations in Latin America, was the $10 billion of foreign bonds underwritten by Wall Street. That was the equivalent of $1.5 trillion in today's economy, and went to borrowers ranging from the Kingdom of Denmark and German industrialists to municipalities from Hamburg to Rio de Janeiro.

On the margin, the 1920s foreign bond market was just the peacetime extension of the US Treasury's vast war loans of 1917–1919. It was these extensive borrowings which allowed many American export customers to finance their purchases, thereby catalyzing the booming domestic economy. Accordingly, during the fifteen years between 1914 and 1929, real GDP
growth had averaged nearly 4 percent annually, a rate that has never again been matched over a comparable length of time.

The trouble was that this prosperity was neither organic nor sustainable. In addition to the debt-financed demand for American exports, stock market winnings and the explosion of consumer debt generated exuberant but unsustainable household purchases of big-ticket durables at home. So when the stock market finally broke, this financially fueled chain of economic expansion snapped and violently unwound.

The first victim was the foreign bond market, which was the subprime canary in the coal mine of its day. Within a few months of the crash, new issuance had dropped 95 percent from its peak 1928 levels, causing foreign demand for US exports to collapse. Worse still, the price of the nearly $10 billion of foreign bonds outstanding also soon plunged to less than ten cents on the dollar, meaning that the collapse was of the same magnitude and speed as the subprime mortgage collapse of 2008.

Foreign debtors had been borrowing to pay interest. When the Wall Street music stopped in October 1929, the house of cards underlying the American export bonanza collapsed. By 1933, US exports had dropped by nearly 70 percent.

The Wall Street meltdown also generated ripples of domestic contraction which compounded the export swoon. Stock market lottery winners, for example, had been buying new automobiles hand over fist. But after sales of autos and trucks peaked at 5.3 million units in 1929, they then dropped like a stone to only 1.4 million vehicles in 1932. Needless to say, this 75 percent shrinkage of auto sales cascaded through the auto supply chain, including metal working, steel, glass, rubber, and machine tools—with devastating impact.

The collapse of these “growth” industries also caused a withering cutback in business investment. Plant and equipment spending tumbled by nearly 80 percent between 1929 and 1933, while nearly half of all the production inventories extant in 1929 were liquidated over the next three years. This unprecedented liquidation of working inventories—from $38 billion to $22 billion—amounted to nearly a 20 percent hit to GDP before the cycle reached bottom.

Overall, nominal GDP had been $103 billion in 1929 but by 1933 had shrunk to only $56 billion. Yet the overwhelming portion of this unprecedented contraction was in exports, inventories, fixed plant and equipment, and consumer durables. These components declined by $33 billion during the four years after 1929 and accounted for fully 70 percent of the decline in nominal GDP.

The underlying story in these data refutes the postwar Keynesian
narrative about the Great Depression. What happened during 1929–1932 was not a mysterious loss of domestic “demand” that was somehow recoverable through enlightened macroeconomic stimulus policies. Instead, what occurred was an inevitable shrinkage in the unsustainable levels of output that had been reached by exports, durables, and a once-in-a-lifetime capital investment boom, not unlike the massive China investment cycle of 1994–2012.

It was not the depression bottom level of GDP during 1932–1933 that was avoidably too low; it was the debt and speculation bloated GDP peak of 1929 that had been unsustainably too high. Accordingly, the problem could not be solved by macroeconomic pump-priming at home. The Great Depression was therefore never a candidate for the Keynesian cure which was inherently inward looking and nationalistic.

The frenetic activity of the first hundred days of the New Deal, of course, is the stuff of historians' legends. Yet when viewed in the context of this implosion of the nation's vastly inflated export/auto/capital goods sector, it's evident that the real cure for depression did not lie in the dozens of acronym-ridden programs springing up in Washington.

Contrary to the long-standing Keynesian narrative, therefore, the New Deal contributed virtually nothing to the mild recovery which did materialize during the six-year run-up to war in 1939. In fact, the modest seesaw expansion which unfolded during that period had been already set in motion during the summer of 1932, well before FDR's election.

THE HOOVER RECOVERY INTERRUPTED

The New Deal hagiographers never mention that 50 percent of the huge collapse of industrial production, that is, the heart of the Great Depression, had already been recovered under Hoover by September 1932. The catalyst for the Hoover recovery was not Washington-based policy machinations but the natural bottoming of the severe cycle of fixed-asset and inventory liquidation after 1929.

By mid-1932, the liquidation had finally run its course because inventories were virtually gone, and capital goods and durables production could hardly go lower. Accordingly, nearly every statistic of economic activity turned upward in July 1932. From then until the end of September, the Federal Reserve Board index of industrial production rose by 21 percent, while rail freight loadings jumped by 20 percent and construction contract awards rose by 30 percent.

Likewise, the American Federation of Labor's published count of industrial unemployment dropped by nearly three-quarters of a million persons between July 1 and October 1. Retail sales and electrical power output also
rose smartly in the months after July, and some core industry which had been nearly prostrate began to spring back to life.

Cotton textile mill manufacturing, for example, surged from 56 percent of capacity in July to 97 percent in October, and mill consumption of wool nearly tripled during the same period. Likewise, the giant US Steel Corporation, which then stood at the center of the nation's industrial economy, recorded its first increase in sixteen months in its order backlog.