by David Stockman

From David Stockman’s Contra Corner. Remarks to the Committee For The Republic, Washington DC, February 2014 (Part 3 in a 6-Part Series) Go to Part 1.

In this setting, Bubbles Ben 1.0 (New York Fed Governor Benjamin Strong) stormed in with a rescue plan that will sound familiar to contemporary ears. By means of his bond buying campaigns he sought to drive-down interest rates in New York relative to London, thereby encouraging British creditors to keep their money in higher yielding sterling rather than converting their claims to gold or dollars.

The British economy was thus given an option to keep rolling-over its debts and to continue living beyond its means. For a few years these proto-Keynesian “Lords of Finance” —- principally Ben Strong of the Fed and Montague Norman of the BOE—-managed to kick the can down the road.

But after the Credit Anstalt crisis in spring 1931, when creditors of shaky banks in central Europe demanded gold, England’s precarious mountain of sterling debts came into the cross-hairs. In short order, the money printing scheme of Bubbles Ben 1.0 designed to keep the Brits in cheap interest rates and big debts came violently unwound.

In late September a weak British government defaulted on its gold exchange standard duty to convert sterling to gold, causing the French, Dutch and other central banks to absorb massive overnight losses. The global depression then to took another lurch downward.

Inventing Bubble Finance : The Call Money Market Explosion Before 1929

But central bankers tamper with free market interest rates only at their peril—-so the domestic malinvestments and deformations which flowed from the monetary machinations of Bubbles Ben 1.0 were also monumental.

Owing to the splendid tax-cuts and budgetary surpluses of Secretary Andrew Mellon, the American economy was flush with cash, and due to the gold inflows from Europe the US banking system was extraordinarily liquid. The last thing that was needed in Roaring Twenties America was the cheap interest rates—-at 3 percent and under—that resulted from Strong’s meddling in the money markets.

At length, Strong’s ultra-low interest rates did cause credit growth to explode, but it did not end-up funding new steel mills or auto assembly plants. Instead, the Fed’s cheap debt flooded into the Wall Street call money market where it fueled that greatest margin debt driven stock market bubble the world had ever seen. By 1929, margin debt on Wall Street had soared to 12 percent of GDP or the equivalent of $2 trillion in today’s economy (compared to $450 billion at present).

The Original Sub-Prime: Wall Street’s 1920s Foreign Bond Mania

As is well known, much economic carnage resulted from the Great Crash of 1929. But what is less well understood is that the great stock market bubble also spawned a parallel boom in foreign bonds—-a specie of Wall Street paper that soon proved to be the sub-prime of its day. Indeed, Bubbles Ben 1.0 triggered a veritable cascade of speculative borrowing that soon spread to the far corners of the globe, including places like municipality of Rio de Janeiro, the Kingdom of Denmark and the free city of Danzig, among countless others.

It seems that the margin debt fueled stock market drove equity prices so high that big American corporations with no needs for cash were impelled to sell bundles of new stock anyway in order to feed the insatiable appetites of retail speculators. They then used the proceeds to buy Wall Street’s high yielding “foreign bonds”, thereby goosing their own reported earnings, levitating their stock prices even higher and causing the cycle to be repeated again and again.

As the Nikkei roared to 50,000 in the late 1980s, the Japanese were pleased to call this madness “zaitech”, and it didn’t work any better the second time around. But the 1920s version of zaitech did generate prodigious sums of cash that foreign borrowers cycled right back to exports from America’s farms, mines and factories. Over the eight years ending in 1929, the present day equivalent of $1.5 trillion was raised on Wall Street’s red hot foreign bond market, meaning that the US economy simply doubled-down on the vendor finance driven export boom that had been originally sparked by the massive war loans to the Allies.

In fact, over the period 1914-1929 the U. S. loaned overseas customers—-from the coffee plantations of Brazil to the factories of the Ruhr—-the modern day equivalent of $3.5 trillion to prop-up demand for American exports. The impact was remarkable. In the 15 years before the war American exports had crept up slowly from $1.6 billion to $2.4 billion per year, and totaled $35 billion over the entire period. By contrast, shipments from American farms and factors soared to nearly $11 billion annually by 1919 and totaled $100 billion—three times more—over the 15 years through 1929.

So this was vendor finance on a vast scale——reflecting the exact mercantilist playbook that Mr. Deng chanced upon 60 years later when he opened the export factories of East China, and then ordered the People’s Bank to finance China’s exports of T-shirts, sneakers, plastic extrusions, zinc castings and mini-backhoes via the continuous massive purchases of Uncle Sam’s bonds, bills and guaranteed housing paper.

Our present day Keynesian witch doctors antiseptically label the $3.8 trillion that China has accumulated through this massive currency manipulation and repression as “foreign exchange reserves”, but they are nothing of the kind. If China had honest exchange rates, it reserves would be a tiny sliver of today’s level.

In truth, China’s $3.8 trillion of reserves are a gigantic vendor loan to its customers. This is a financial clone of the $3.5 trillion equivalent that the great American creditor and export powerhouse loaned to the rest of the world between 1914 and 1929.

Needless to say, after the October 1929 crash, the Wall Street foreign bond market went stone cold, with issuance volume dropping by 95 percent within a year or two. Thereupon foreign bond default rates suddenly soared because sub-prime borrowers all over the world had been engaged in a Ponzi—-tapping new money on Wall Street to pay interest on the old loans.

By 1931 foreign bonds were trading at 8 cents on the dollar—-not coincidentally in the same busted zip code where sub-prime mortgage bonds ended up in 2008-2009.

Still, busted bonds always mean a busted economic cycle until the malinvestments they initially fund can be liquidated or repurposed. Thus, the 1929 Wall Street bust generated a devastating crash in US exports as the massive vendor financed foreign demand for American farm and factory goods literally vanished. By 1933 exports had slipped all the way back to the $2.4 billion level of 1914.

1929-1933 Foreign Bond and US Export Bust: True Source of the Great Depression

That’s not all. As US export shipments crashed by 70 percent between 1929 and 1933, there were ricochet effect throughout the domestic economy.

This artificial 15-year export boom had caused the production capacity of American farms and factories to become dramatically oversized, meaning that during this interval there had occurred a domestic capital spending boom of monumental proportions. While estimated GDP grew by a factor of 2.5X during 1914-1929, capital spending by manufacturers rose by 7X. Auto production capacity, for example, increased from 2 million vehicles annually in 1920 to more than 6 million by 1929.

Needless to say, when world export markets collapsed, the US economy was suddenly drowning in excess capacity. In short order, the decade-long capital spending boom came to a screeching halt, with annual outlays for plant and equipment tumbling by 80 percent in the four years after 1929, and shipments of items like machine tools plummeting by 95 percent.

Not surprisingly, in the wake of this drastic downshift in output, American business also found itself drowning in excess inventories. Accordingly, nearly half of all production inventories extant in 1929 were liquidated by 1933, resulting in a shocking 20 percent hit to GDP—a blow that would amount to a $3 trillion drop in today’s economy.

Finally, Bubbles Ben 1.0 had induced vast but temporary “wealth effects” just like his present day successor. Stock prices surged by 150 percent in the final three years of the mania. There was also an explosion of consumer installment loans for durable goods and mortgages for homes. Indeed, mortgage debt soared by nearly 4X during the decade before the crash, while boom-time sales of autos, appliances and radios nearly tripled durable goods sales in the eight years ending in 1929.

All of this debt and wealth effects induced spending came to an abrupt halt when stock prices came tumbling back to earth. Durable goods and housing plummeted by 80 percent during the next four years. In the case of automobiles, where stock market lottery winners had been buying new cars hand over fist, the impact was especially far reaching. After sales peaked at 5.3 million units in 1929, they dropped like a stone to 1.4 million vehicles in 1932, meaning that this 75 percent shrinkage of auto sales cascaded through the entire auto supply chain including metal working equipment, steel, glass, rubber, electricals and foundry products.

Thus, the Great Depression was born in the extraordinary but unsustainable boom of 1914-1929 that was, in turn, an artificial and bloated project of the warfare and central banking branches of the state, not the free market. Nominal GDP, which had been deformed and bloated to $103 billion by 1929, contracted massively, dropping to only $56 billion by 1933.

Crucially, the overwhelming portion of this unprecedented contraction was in exports, inventories, fixed plant and durable goods—the very sectors that had been artificially hyped. These components declined by $33 billion during the four year contraction and accounted for fully 70 percent of the entire drop in nominal GDP.

So there was no mysterious loss of that Keynesian economic ether called “aggregate demand”, but only the inevitable shrinkage of a state induced boom. It was not the depression bottom of 1933 that was too low, but the wartime debt and speculation bloated peak in 1929 that had been unsustainably too high.

Go to Part 4.