The Great Deformation (37 page)

Keynes fancied himself a dandy, of course, and would never have been caught wearing homespun attire from the equivalent of Gandhi's loom. But when it came to entire nations and their unwashed masses, it is not at all
surprising that he thought that nationalistic and autarkic Nazi Germany was the most likely candidate for early adoption of his program. He even took personal care to insure that his works were always available in German.

Perhaps Keynes' newfound distain for international commerce was colored by his experience as a currency speculator during the 1920s when he had repeatedly made bets on the whims of national policy-makers. The topic of Keynes' currency bets was always the same—that is, when and at what parities would various countries—including Great Britain—“resume” convertibility and fixed exchange rates.

Indeed, the trials and tribulations of France, the Belgium, Italy and others during their postwar quest for “resumption” of currency convertibility embodied an unassailable lesson that Keynes had surely grasped. The scope for domestic fiscal policy action and macroeconomic management became sharply constrained when nations embraced honest, gold-redeemable international money.

So during the prolonged debate over British resumption, Keynes became a shrill opponent of the gold standard and the idea of international money as the world had previously known it. The vainglorious professor from Cambridge had thus arrived at the conclusion that “Keynesianism in one country” was the wave of the future and that his nostrums required an essentially closed economy and national fiat money.

In this sense, Roosevelt was the tribune who made Keynesianism possible. By his obdurate rejection of the advice of his internationalist advisors—Lewis, Warburg, Hull, Glass—FDR smothered the last impulse to resurrect a liberal world economic order and valid international money. Roosevelt the Fisherite thus made full strength Keynesianism ultimately possible.

To be sure, having shed the shackles of international monetary discipline, the New Deal didn't really know what to do with its new found freedom of action. As has been seen, many of the New Deal's hallmark legislative enactments—the NRA, AAA, the Wagner Act and the Fair Labor Standards Act—were exercises in economic restriction rather than Keynesian demand expansion.

HENRY MORGENTHAU'S LAST STAND FOR BUDGET ORTHODOXY: WHY US FISCAL BANKRUPTCY TOOK TIME

The irony of the New Deal is thus striking. Even when there was virtually no monetary check on deficit spending, it did not go all-out for Keynesian stimulus owing to a vestigial state of mind; that is, an inculcated belief in balanced budget orthodoxy.

Adherence to the old-time fiscal religion by policy makers was a crucial rearguard force which retarded the adoption of Keynesian policies during the initial four decades after the New Deal. Indeed, in a double dose of irony, it was the abandonment of balanced budget orthodoxy by the GOP after 1980 that led to the nation's rapid fiscal demise thereafter. Yet this eventuality was latent the day FDR embraced the Thomas Amendment and the end of sound money.

As it happened, the principle agent of fiscal orthodoxy in FDR's inner circle was Treasury Secretary Henry Morgenthau. Morgenthau was second only to FDR himself in his ardor for Professor Fisher's radical monetary doctrine of the compensated dollar, but like so many subsequent policy makers of the interwar generation, Morgenthau kept his fiscal and monetary doctrines compartmentalized.

Time and time again Morgenthau fought to restrain New Deal spending and deficits. His famous diary is literally chockablock with expressions of fiscal rectitude, yet the fiat dollar régime he so enthusiastically embraced would have permitted deficits of a scale that would have pleased even Larry Summers.

By the eve of World War II, an exhausted Morgenthau penned an entry expressing a complete lack of faith in deficit spending: “We have tried spending money. We are spending more than we have ever spent before and it does not work … I say after eight years of this administration that we have just as much unemployment as when we started…. And an enormous debt to boot.”

The fiscal trends which alarmed Treasury Secretary Morgenthau, however, turned out to be worrisome only by the chaste standards of the past. During FDR's six peacetime budgets (1934–1939), federal spending never reached even 10 percent of the national economy and the fiscal deficit averaged just 3.9 percent of GDP. And that was during the greatest depression in world history.

American politicians thereafter gradually learned that the ancient discipline of honest money had been lifted, so they steadily pushed out the fiscal boundaries. The fiscal deficit during 1975–1980, for example, averaged 3 percent of GDP and then raced past the New Deal record to an average deficit of 4.3 percent of GDP during the Reagan Administration. And this was during an eight-year span which included six years of “morning in America.” Accordingly, the way was paved for the fiscal lunacy of the George W. Bush era and the explosive last gasp of Keynesianism under Obama.

As the curtain closed on the 1930s, Morgenthau's doctrinal contradiction was just the most exaggerated case of the split-screen attitude of the
New Deal's conservative wing. Many of the stalwart southern Democrats who were critical to the Roosevelt coalition—such as Vice-President John Nance Garner, RFC head Jesse Jones, Senator Jimmy Byrnes of South Carolina, and Senator Walter George of Georgia—had generally welcomed soft money and dollar depreciation, even as they remained wary of fiscal deficits.

Eventually, however, the fiscal orthodoxy which had been part and parcel of the gold standard world faded away as its adherents like Morgenthau and the conservative southern Democrats left the scene. Still, even as they went through the motions of their rearguard battle against deficits, the destructive fiscal legacy of the New Deal was just getting started.

The seeds of crony capitalism had been planted in the farm belt and among crippled economic sectors like the railroads and the merchant marine. The ticking fiscal time bomb of social insurance had been institutionalized, even as a régime of industrial union monopoly cast a long shadow on the national economy's ability to shoulder the cost burden.

Likewise, the federal agencies which would fuel the housing mania had been chartered, and only a frail regulatory harness on the banks held the vast moral hazard of deposit insurance temporarily in check. Most important of all, FDR's final destruction of the gold standard had paved the way for open-ended statist intervention and hyperactive management of the domestic economy.

This misguided and fiscally cancerous project would soon be embraced by both parties. It was a development which was bound to end in the triumph of crony capitalism and the fiscal bankruptcy of the nation.

CHAPTER 10

 

T
HE NEW DEAL'S AD HOC STATISM WAS EVENTUALLY SUPERSEDED
by the real thing: the full-bore warfare state spawned by the Japanese attack on Pearl Harbor. Under the exigencies of total war, all of the tools of modern fiscal expansion and monetary manipulation were discovered, tested, amended, and perfected.

But when the peace came in 1945, the victory of these warfare state–inspired policy tools was neither complete nor immediate. Indeed, over the next quarter century the canons of financial orthodoxy found intermittent, and sometimes poignant, expression under Presidents Harry Truman and Dwight D. Eisenhower, and the long-reigning Fed chairman William Mc-Chesney Martin. Even President John F. Kennedy kept orthodoxy alive, at least in the Treasury Department and its international dollar policies.

So the road from Pearl Harbor to Richard Nixon's decision to default on the nation's Bretton Woods obligation to redeem its debts in gold, eventually ushering in printing-press money and giant fiscal deficits, is important to retrace. In the interim there occurred episodes of fiscal and monetary discipline that have long since been purged from mainstream memory. Yet these were signal moments of inspired governance which underscore just how much was lost with the waning of the old-time financial orthodoxy.

One was President Harry Truman's insistence on financing the Korean War the honest way, with higher current taxes. Another was Eisenhower's refusal to adopt tax-cut stimulus during the two recessions on his watch, thereby enabling him to achieve his highest fiscal priority: balancing the federal budget.

Still another shining moment came in August 1958 when Fed chairman William McChesney Martin moved to “take away the punch bowl” in order to discourage stock market speculation only four months after the economic recovery had begun. And rarely noted is that President Kennedy's
first economic policy address was a ringing commitment to maintain the nation's Bretton Woods obligations and to defend the gold dollar.

It is entirely accurate and warranted to say that Nixon's embrace of Professor Friedman's floating paper dollar was the fatal turning point which brought a final end to sound money. Yet what the road to August 1971 also demonstrates is that Tricky Dick's abomination was not inevitable. There was, in fact, a twilight of sound money along the way.

WAR FINANCE AND THE RISE OF THE FED'S OPEN MARKET BOND AND BILL BUYING

Once war was declared, the Roosevelt administration dusted off the techniques discovered during the Great War mobilization of 1917–1918 and soon imposed a complete command-and-control régime that reached into every nook and cranny of the American economy. The steel, auto, metal-working, machinery, and other heavy industries were commandeered to make ships, planes, and tanks. Production of housing, autos, household durables, and other discretionary items was eliminated almost entirely.

In a civilian economy bereft of consumer goods, all prices and wages were put under a straitjacket of bureaucratic controls. Likewise, private incomes were drafted into war service either by means of confiscatory taxation or as quasi-forced savings via the incessant war bond campaigns.

Not surprisingly, the money markets and the capital markets went into deep hibernation in this completely war mobilized economy. Likewise, the Federal Reserve became the financing arm of the warfare state. Making short shrift of any pretense of Fed independence, Treasury Secretary Henry Morgenthau simply decreed that interest rates on the federal debt would be “pegged.” Treasury bills would yield three-eighths of 1 percent and long-term bonds would pay a 2.5 percent coupon.

Obviously, the only way to enforce this peg was for the nation's central bank to purchase any and all Treasury paper that did not find a private sector bid at or below the pegged yields. Accordingly, the Fed soon became a huge buyer of Treasury securities, thereby “monetizing” federal debt on a scale never before imagined.

The magnitude of this bond- and bill-buying campaign is dramatically evident in the Fed's balance sheet footings, which showed holdings of $2.3 billion of Treasury debt at the start of the war. By the end of 1945, these holdings had soared to $24.3 billion, a twelvefold expansion during the four years of world war.

The nation's central bank thus became schooled in the art of rigging the government bond market and the Treasury yield curve by persistent massive open-market purchases of Treasury paper. Today this is business as
usual, but then it was a radical departure, a theretofore rarely used tool that now became institutionalized owing to the exigencies of wartime finance.

The Fed opened its doors in November 1914. But owing to the exigencies of wartime its purpose and modus operandi were twice turned upside down during its first thirty-one years. It can be fairly said that the Fed became a permanent denizen of the government debt market during its service to the warfare state, forging the T-bill standard, as it were, in the crucible of war. But this massive government bond buying was the very opposite of what its legislative authors had in mind when enacting the Federal Reserve Act of 1913.

A BANKER'S BANK WHEN THERE WAS NO PUBLIC DEBT AND NO RELATIONS WITH WALL STREET

Schooled in the English banking tradition and “real bills” monetary doctrine, the chairman of the House banking committee, Carter Glass, had seen the new Federal Reserve as an agent of the commercial loan market. In fact, he fervently believed that the Fed should not conduct operations in the government bond market, and certainly never envisioned that it would become a massive repository of government debt.

Accordingly, it was intended that the new system would provide liquidity to business and industry through a “rediscounting” process in which the “reserve” banks supplied cash advances to local commercial banks. Such “reserve credit” extensions were to be collateralized by the short-term business loan books of participating banks.

The commercial banking system would thereby be backstopped by a reliable source of cash to meet unexpected depositor withdrawals, while obviating the need for banks to call in business loans and disrupt the flow of commerce. The Federal Reserve System, therefore, was intended to be a “banker's bank,” not an agent of national economic management. This founding charter has been literally blotted out of modern day discussions, as has the fact that the original Fed could not have operated through the government bond market in any event because in 1913 there wasn't one.

Total federal debt outstanding at the time of the Fed's creation was $1.2 billion. This amounted to only 3 percent of GDP and $12 per capita in the money of the day, a figure which would still be only $400 per capita in today's massively depreciated dollar. So the Fed was established during an era when policy makers didn't much cotton to running their government on debt.