The Great Deformation (40 page)

Consequently, Martin had been exposed at an early age to dinnertime monetary discourses by his father's notable colleagues including Benjamin Strong, the powerful chief of the New York Fed, and H. Parker Willis, the era's leading authority on money and banking and the technician who had actually drafted much of the 1913 act.

Professor Willis was also a learned proponent of the classical English banking model, which held that commercial banks should lend only against liquid trade receivables, not real estate, corporate securities, or other illiquid collateral. Indeed, the modern device of an unsecured “cash flow” loan would have struck him as pure heresy.

Willis advocated this stringent approach to permissible bank assets not because he was an anti-market regulator, but because he recognized the inherent danger of fractional reserve deposit banking. The only way to have a stable banking system when the vast majority of deposits are callable on demand, he maintained, was to keep assets equally short term and self-liquidating.

For this reason, the Federal Reserve banks in the framework designed by Willis and his colleagues had a very narrow mandate. The sole function of the “reserve banks” was to help keep the commercial banking system liquid by advancing cash to member banks against their own liquid trade credits whenever they presented them at the discount loan window as collateral.

The central banking system established in 1913 was therefore not in the economic management business and did not need to know whether GDP was rising or falling, or whether housing starts were robust or punk. Most especially, it would not have discounted even a scrap of the illiquid toxic securities that the Bernanke Fed accepted as collateral in September 2008. The $100 billion of advances it provided Morgan Stanley, for example, to
cover up the firm's bald-face lie that it was still solvent would have been unthinkable.

The reason that the Willis-designed Fed had been indifferent to Wall Street troubles was that its congressional sponsors, especially Carter Glass, had a profound fear of credit-based speculation. That's why there was no provision in the original act for the Fed to purchase or lend against government debt or to carry out the open market purchase and sale of investment securities.

All of these latter adaptations were designed to inject central bank credit into the financial system for the purpose of stimulating borrowing, spending, and GDP. But Willis believed that central bank credit would be invariably diverted into speculative lending and stock market gambling.

When the New York Fed opened the credit spigots in the summer of 1927, for the laudable purpose of helping the British adhere to their gold standard obligations, he was soon proven correct. The outcome was a giant margin loan bubble which fueled an unprecedented speculative mania on Wall Street during the next two years.

By the time of Martin's reign at the Fed, of course, Professor Willis's doctrines had been steadily diluted and compromised, especially after the Fed became the fiscal agent for the wartime needs of the Treasury. Yet his fundamental admonition about the dangers of unchecked credit inflation and bank-enabled commodity and stock speculation remained central to Martin's monetary philosophy.

In fact, Martin had gotten his Wall Street education firsthand and at an early age. When he was just thirty-one years old he was chosen to become president of the New York Stock Exchange. His job assignment was to sweep clean the Augean stables in the wake of a scandal which in 1938 finally brought down Richard Whitney, the longtime head of the exchange, and his old-guard associates.

Martin accomplished this mission with aplomb, taking away from his six-year tenure a widely praised record of reform in exchange practices and accommodation to the new SEC regulatory régime. But far more important, he also gained a deep appreciation for the degree to which rampant margin lending had turned the stock market into a veritable gambling casino in the run-up to the 1929 crash.

MARGIN LOANS AND THE LESSONS OF 1929

These so called brokers' loans were a volatile form of hot money and were callable on a moment's notice. At the time of the market peak, they had amounted to about 9 percent of GDP, which would amount to the not inconsiderable sum of $1.4 trillion in today's economy.

Moreover, as the speculative wave reached its final peak, broker loans outstanding had ballooned wildly. Outstanding margin credit to stock speculators had increased by 50 percent in the final twelve months of the stock mania.

When viewed through the lens of the carnage which followed the crash, Martin had little trouble seeing that it was this volcanic mountain of margin debt which had lifted the stock averages to insane levels. He thus deeply believed that keeping speculative credit out of Wall Street was essential to the revival of an honest stock market and healthy national economy.

Martin also had little doubt that the Fed's easy-money policies during the later 1920s, particularly the aggressive easing in 1927, had fueled the massive flow of speculative credit into Wall Street. That cardinal fact was lost on postwar historians and monetarists, however, because the margin credit bubble had been hidden between the lines of the commercial banking system loan data. Between 1925 and 1929, for example, bank loans outstanding had increased by a seemingly modest $7.5 billion, or 5 percent, annual rate.

Yet buried in these quotidian aggregates was the fact that bank loans to business and industry, that is, to the real economy, had declined sharply during this four-year period. Consequently the entire reported gain, and then some, was due to the explosion of Wall Street brokers' loans.

The decline of business loans in the real economy was partially the result of improved internal corporate cash flows as the 1920s boom reached its apex. However, the primary driver of this reduced appetite for bank credit was far more perverse, as had been repeatedly pointed out by Benjamin Anderson, the era's most prescient working economist.

According to Anderson, who was chief economist of the Chase National Bank, the boom on Wall Street had permitted corporations to raise far more cash from new stock and bond issues than they needed to meet actual investment needs. Consequently, they not only used this “excess cash” to pay down bank loans, but also recycled much of it straight back to the Wall Street call money market; that is, industrial companies became part-time bankers.

Nearly 60 percent of the total $9 billion of brokers' loans outstanding on the eve of the crash had been advanced not by the banks, but by wealthy investors and corporations recycling cash from earlier stock market winnings. In this manner, the excess liquidity from the Fed's money-printing experiments in the mid-1920s had drained into Wall Street and fueled a self-perpetuating cycle of financial speculation.

Ironically, this same gambit reappeared about sixty years later when the Japanese invented a whole theory called “zaitech” to explain how companies
could prosper by moonlighting as financial engineers. In the Japanese version, companies sold stock and convertible debt at the vastly inflated market prices which had been fueled by the Bank of Japan's post-1985 money-printing spree. Japanese corporations then recycled the resulting cash proceeds into stock market speculation, which resulted in even more reported profits and still higher share prices.

Not surprisingly, when the Bank of Japan was forced to puncture the resulting runaway financial bubble in 1989, as the Fed had been required to do in 1928–1929, the zaitech-based house of cards collapsed almost instantly. Japan thus experienced a replay of the very same Wall Street movie which had played six decades before.

In contrast to his present-day Japanese and American counterparts, William McChesney Martin was schooled in the classic doctrines on money and banking, and did not need a rerun of the 1929 crash to know that leveraged speculation in the stock market needed to be avoided at all costs. Consequently, the hallmark of his tenure was his famous quip that the job of the Fed “is to take away the punch bowl just as the party gets going.”

WHEN MARTIN TOOK THE PUNCH BOWL AWAY FROM A FOUR-MONTH-OLD (RECOVERY)

At no time was Martin's resolve to lean hard against a recurrence of speculative excess more evident than in August 1958, when the Fed moved to tighten policy just four months after the start of recovery from the recession of 1957–1958. Not surprisingly, his tool of choice was to raise the margin requirement on stock trading accounts from 50 percent to 70 percent, along with an increase in the Fed's discount rate for emergency borrowings by member banks.

Moreover, three months later the Fed raised its discount rate again. And then to make sure that its message was not misunderstood, it boosted the margin requirement still higher, requiring stock traders to pony up 90 percent cash on each new trade.

By the standards of the day, the Fed had every reason to take this aggressive action. Between 1954 and 1957, bank loans outstanding had soared at a 12 percent annual rate, and CPI inflation had ticked up to 3.6 percent in the year ending March 1958. The Martin Fed found both of these trends deeply troubling and believed that, if left unchecked, they posed dire threats to the Fed's fundamental mission of maintaining the purchasing power of the dollar and financial stability.

Furthermore, today's central bank sophistries, such as levitating the stock market to generate economic growth through the “wealth effect” and
discounting reported inflation by excluding items such as food and energy, had not yet been invented. Accordingly, the Fed continued to tighten monetary policy throughout the course of 1959.

Moreover, these moves were decisive. Unlike the ineffectual baby-step hikes of 25 basis points that Alan Greenspan later favored, Martin raised the discount rate by a full percentage point on each of several occasions, and also further tightened stock market margin lending.

In one of its post-meeting statements the Fed zeroed in directly on excessive bank lending. Unlike today's debt-besotted central bankers, the Martin-era Fed worried about too much credit growth, not too little, saying that it was “restraining inflationary credit growth in order to foster sustainable economic growth.”

As the year drew to a close, then, Chairman Martin had well and truly demonstrated what “taking away the punch bowl” actually meant. Open market interest rates rose from 1 percent in June 1958 before the tightening started to 5 percent by December 1959, and the Treasury bond yield rose from under 3 percent to nearly 5 percent during the same period.

At the same time, the curative effect of monetary restraint was soon evident in the rapid return of price stability. During 1959, consumer price increases fell back to the 1 percent level, where they remained through 1963.

In a further marker that the inflationary threat had been quelled, the substantial outflow of gold from the United States which had occurred during 1958 owing to inflation fears was staunched by the Fed's resolute stance. US gold stocks remained stable for several years thereafter.

Nor was sound money purchased at the price of a weak economy. Real GDP rebounded at a 6.4 percent annual rate in 1959 and averaged 4.3 percent annually during the five years after the Fed removed the punch bowl.

Indeed, under Martin's leadership the Fed did achieve something of a golden age once the macroeconomic disruptions of the Korean War had passed. Thus, between 1954 and 1963, real GDP growth averaged 3.4 percent while annual CPI inflation remained subdued at 1.4 percent.

There was no subsequent nine-year period that had a better combined performance of these core variables. And none which left the overall economic and financial system so healthy and stable.

CHAPTER 11

 

C
HAIRMAN WILLIAM MCCHESNEY MARTIN'S QUEST TO RESTORE
sound money was aided immeasurably during the 1950s by a fiscal policy backdrop that would never again recur. Beginning with Truman's tax financing of the Korean conflict, monetary policy was supported by two successive presidents who were firmly committed to budgetary discipline and who were willing to expend political capital to achieve it.

As it happened, it was Eisenhower who really brought the old-time religion back to the center of peacetime fiscal policy. Ike was a military war hero who hated war. He was also the former supreme commander of the costliest military campaign in history and revered balanced budgets. Accordingly, Eisenhower did not hesitate to wield the budgetary knife, and when he did the blade came down squarely on the Pentagon.

THE FOLLY OF WAR DEFICITS

The essence of Eisenhower's immense fiscal achievement, an actual shrinkage of the federal budget in real terms during his eight-year term, is that he tamed the warfare state. In so doing, he paved the way for Uncle Sam to pay his bills out of current taxation for the better part of a decade.

The enormity of this achievement can only be fully appreciated by contrast with its opposite—that is, three devastating fiscal setbacks during the next half century under Lyndon Johnson, Ronald Reagan, and George W. Bush. In each case, the plunge of the nation's fiscal accounts deep into the red was triggered by a resurgence of the kind of massive warfare state budgets that Ike so resolutely resisted.

In bringing down the fiscal roof, all three post-Eisenhower defense surges were enabled by a vital accomplice: Keynesian theories of prosperity
management that manifested themselves in both a leftist “new economics” version and rightist “supply side” variant. The pretension of both ideologies was that the correct policy action by Washington could spur permanent economic growth at extraordinary rates, such as 5 percent annually or even better. Consequently, by embracing this high GDP growth illusion, the White House occupants during these three episodes were led to believe that they could have war budgets without war taxes.