PRINCIPIOS

The decline in business conditions accelerated sharply after the international crisis as those who controlled businesses were the capitalists and capital preservation was their primary objective. Bank failures were at record levels in the last quarter of 1931, and many industries, particularly railroads, began to suffer severe losses. The Gross National Product dropped 7.7% in constant dollars. Unemployment approached 25% by the end of the year.137

While National Income had declined by 31% in current dollars from the peak, the income of all businesses fell 65%. Corporate profits had declined from 10% of National Income to a loss equal to a negative 1 ½% of National Income.138

At the time, hardly anyone believed that more and cheaper credit availability would have stimulated business, because even with interest rates of zero, the real cost of more borrowing was very high and the industries which needed credit weren’t good credits.139

It was unimaginable then, and comparably implausible to us now, that banks and other investors will lend to unsound borrowers in a deflation.

In September 1931, the dollar ceased to be a safe haven. Since other countries defaulted and devalued, their needs for dollars fell and the United States’ budget and credit problems started to raise concerns140

that the U.S. would have to choose between default and devaluation. So, after the sterling crisis and the U.S. banking crisis worsened, gold reserves fell, the economy fell, and there was a run on banks.141

U.S. gold reserves increased right up to the week ending Saturday, September 19, 1931—the day before the United Kingdom decided to suspend gold payments. The U.S. gold outflow began on the following Monday, when foreign banks, including the Bank of France, bought almost $100 million in gold from the Federal Reserve. Within three weeks of the suspension of sterling, the United States lost approximately 10% of its reserves.142

The Fed raised the discount rate substantially, hoping that higher interest rates would attract investors back.143

To counter the gold outflow, the New York Federal Reserve Bank raised its discount rate from 1 ½% to 2 1/2% on October 8th_{, but foreign investors’ concerns had reached the point of not being affected by changes in interest} rates. Rumors abroad that the United States would go off the gold standard as the U.K. did prompted a record one-day gold outflow on October 14th_{. The New York Federal Reserve Bank discount rate was raised another 1%} to 3 ½% the next day. The next week, France agreed not to withdraw any more gold from the United States, and both countries agreed to consult each other before advancing any new proposals for extending the war debts moratorium.144

However, the supply-demand imbalance for dollars continued to worsen as the Federal government’s deficit became too big to fund in September 1931, so the Federal Reserve bought U.S. long bonds.145

In mid-October Canada prohibited the exportation of gold , causing investors who tried to protect themselves by hiding in gold to be trapped.

Besides foreigners withholding gold,146 _{there was domestic hoarding of gold and currency by U.S. individuals.}147 There was a sharp contraction in bank deposits generally during the last quarter of 1931 as foreigners pulled out and individuals shifted bank deposits into gold and cash hoarding.148 _{Reflecting this, currency in circulation,} including gold and silver, jumped by about 20% from June 1931 to December.149

The Fed’s tightening to keep capital produced a cash shortage that caused loans to be called. Bankers began to call in loans from many sectors, trying to increase their cash reserves. Many homes and farms were forced into foreclosure because their loans weren’t renewed. Company bankruptcies were increased as creditors called in all the loans to debtors. The contraction in the money supply was not caused by the Federal Reserve intentionally, but because of the behavior seeking safety via the withdrawal of foreign capital, domestic hoarding, and the foreclosure on property which further depressed the values of tangible assets.150

The Federal Reserve was given authority to buy U.S. T-bonds in April 1932 so it bought them as deficits increased and foreign investors withdrew funds. Because of the balance of payments imbalance being financed through the Fed’s liquidity creation, a currency crisis developed.151

The chart below shows Fed purchases and holdings of government securities from January 1931 to December 1932. As shown, the balance sheet was significantly expanded by this process.

Through the 1920s and up until 1933, the money supply was essentially linked to the supply of gold and, through the multiplier effect, the supply of money created the supply of credit and that credit growth funded economic growth. In the 1920s,152

$1 in gold led to $13 in debt as money was lent and relent to create an amount of debt that was many times the supply of money. Of course, debt is the promise to deliver money, so when this ratio became high, the system became precariously balanced. When credit starts to fall, usually because there is not enough money to meet debt obligations, credit falls and the demand for money increases, so the ratio falls.

When the supply of money is linked to the supply of gold, debt must contract more and economic activity must also fall more than if the supply of money can be increased. When investors lose confidence in a bank or the government and they hoard their assets (e.g., in cash and gold), as was the case during the Depression, the hoarding reduces the availability of credit. Since the Fed could not create gold, its only option was to create paper money. It was then believed that central banks could not create much paper money while on a gold standard because such a move would revive Gresham’s law of bad money driving out the good.153

If investors wanted to cash in their US bonds, notes and bills at the same time, the government would be forced to choose between not increasing the money supply, which would lead to interest rates rising, or printing money. That is because not enough cash as measured through M1 exists to cover all the debt obligations. Of course, as long as investors feel comfortable with bonds as a “store of wealth,” and don’t need the cash, everything is fine. But when confidence in bonds is lost and/or cash is needed, investors run in the direction of cash and gold. There is simply not enough cash to go around, especially as gold is taken out of reserves, and a massive contraction takes place. When nations began to default on their bonds and the need of the federal governments to borrow more than investors would lend, confidence in bonds and government debt maintaining their value gave way, driving investors into gold and cash for safety. Because debt multiplies the value of these tangible assets, it creates a bubble which eventually comes to a head creating a stampede into cash. This has been true through history, all the way back to Roman times and before.154

During August, runs for cash closed most of the banks in Toledo and Omaha and banks in L.A., New York and Brooklyn. Bank failures accelerated in July and August.155

In the Depression, the bank failures were primarily due to the declines in corporate bond, stock, real estate, and commodities values, as well as declines in business generally, which destroyed asset values and income. The weakness of the economy became apparent only in the summer months, as real estate foreclosures accelerated, wage and salary cuts were initiated in major industries, and domestic and international trade fell off sharply. Then, as now, real estate was one of the weakest areas of the economy. Real estate values had collapsed earlier in some regions, particularly in Florida and South Carolina.

152 _{Armstrong p. 370} 153 _{Armstrong p. 370} 154 _{Armstrong p. 371} -75 -25 25 75 125 175 225 275 325 375

Jan-31 Apr-31 Jul-31 Oct-31 Jan-32 Apr-32 Jul-32 Oct-32

300 500 700 900 1100 1300 1500 1700

This problem spread to New York where there were foreclosures on commercial properties and rental buildings by savings banks and life insurance companies which produced a rash of foreclosure auctions beginning in June 1931.156 _{Then, as now, the collapse of real estate values generated increased uneasiness towards the banks. The} bubble in real estate was reflected in real estate loans by national banks doubling from 5% of loans in 1928 to 10% in 1930.157

Because illiquid assets could not be sold to raise liquidity, President Hoover wanted to allow the Federal Reserve to accept illiquid collateral to lend against.158

On December 10, 1931, Chase securities announced write-downs of $120 million to account for losses in securities still carried at pre-Crash values. Similar credit problems were pervasive. Banks’ net profits were reduced from over $556 million in 1929 to $306 million in 1930 to virtually zero in 1931. Securities losses at banks were a record $264 million in 1931 compared with $109 million in 1930 and $95 million in 1929. Loan losses were a record $295 million compared with $195 million in 1930 and $140 million in 1929. Interest earned on loans, bills and commercial paper dropped from $1.6 billion in 1929 to $1.3 billion in 1930 and $1.1 billion 1931. Then, as now, the banks were squeezed from every direction.159

All sorts of moves were made to hide the real values of assets of banks. Such attempts to hide losses in deleveragings are typical. For example, laws were changed to preserve the fiction of profits, a moratorium was declared on removing railroad bonds from the legal investment list in New York State, so that banks did not have to realize losses on the sale of bonds taken off the “legal list”, and federal authorities allowed banks to carry at par all U.S. bonds and other bonds within the four highest credit ratings (Baa to Aaa). 160