George H. Blackford, Ph.D.

 Economist at Large

 Email: george(at)


It ain't what you don't know that gets you into trouble.

It’s what you know for sure that just ain't so.
Attributed to Mark Twain (among others)


Economic Papers
Political Essays


In 1955, Walter Reuther, head of the US car workers’ union, told of a visit to a new automatically operated Ford plant. Pointing to all the robots, his host asked: “How are you going to collect union dues from those guys?” Mr Reuther replied: “And how are you going to get them to buy Fords?”

Martin Wolf

horizontal rule

Then and Now: 1929-2008

The Dynamic Role of Central Banks in the Economy

The Third Boston Symposium on Economics
Northeastern University Economics Club

George H. Blackford (02/10/2014)

horizontal rule

In discussing The Dynamic Role of Central Banks in the Economy, I am going to begin with a reexamination of some economic history—history that I believe helps to explain the role played by the Federal Reserve in the current financial crisis, as well as what I believe to be the fundamental economic problem we face today.

Founding of the Federal Reserve

The Federal Reserve was founded in 1913 in an attempt to deal with what was perceived, at the time, to be the central problem of the National Banking System.  Namely, the inability of this system to deal with increases in the demand for currency without placing a strain on banks and their ability to make loans. 

This problem was dealt with by creating the Federal Reserve as a central bank with the power to print its own currency.  It was believed at the time that, given this power, the Federal Reserve would be able to at least manage, if not eliminate, the financial crises that had plagued the National Banking System by lending currency to sound banks during times of financial stress while allowing unsound banks to go out of business in an orderly manner.

While the Federal Reserve was able to solve the demand for currency problem, it was not able to solve the financial crisis problem.  The inadequacy of the Federal Reserve in this regard became painfully obvious as the economy worked its way through the Roaring Twenties and into the Great Depression of the 1930s. 

The Roaring Twenties and Great Depression

The 1920s began with a mild recession in 1920-1921 followed by a speculative bubble in the real estate market.  The real estate bubble burst in 1926 and was superseded by a speculative bubble in the stock market.  There was a mild economic downturn in 1927, a brief recovery that same year, and another mild downturn in the summer of 1929.  Then, the stock market bubble came to a dramatic climax in the fall of that year.  (Galbraith Friedman Meltzer Kindleberger Eichengreen Kennedy)

The Crash of 1929 began on October 24—a day that became known as Black Thursday  when the market dropped dramatically in the morning and recovered somewhat in the afternoon.  While prices rallied on Friday, there were two more black days to come.  When trading resumed after the weekend, the Dow fell 13% on Black Monday and then an additional 12% on Black Tuesday.  There were rallies that followed, but, overall, the stock market lost 80% of its value from its high in 1929 to its low in 1932 and the Dow fell by almost 90%

The Crash of 1929, and the events that followed, shook the confidence of the public in the banking system.  Since there was no such thing as deposit insurance until 1933, the result was a run on the banking system that began in the fall of 1930.  This led to utter panic as financial institutions tried to cut their losses by recalling existing loans and refusing to make new loans, not just loans collateralized by real estate and stocks, but all loans.  This forced debtors whose loans were called or who could not refinance their loans to sell the collateral underlying their debts—as well as other assets—in order to meet their financial obligations.  (Fisher)

As this drama unfolded, it became impossible for the Federal Reserve to resolve the situation by simply providing currency to sound banks while allowing unsound banks to go out of business.  The problem was not that sound banks needed cash to meet their depositor’s demands for currency.  The problem was that the forced sale of assets throughout the system caused asset prices to fall, which, in turn, caused the value of the collateral underlying bank loans to fall below the value of the loans that had been made.  This drove otherwise sound banks into insolvency, and banks became unsound faster than they could be saved. 

By the time the banking crisis reached its climax in 1933 we were in the depth of the Great Depression.  Some 4,000 banks and 1,700 savings and loans went under in that year alone, and some 10,000 banks had gone out of business since 1929 along with 129,000 other businesses.  Over 11 million people lost their jobs as unemployment rose to 25% of the labor force.  (ERP)  The total value of goods and services produced in the United States fell by 46%, the level of production by over 30%.  And just as happened in 2008, the financial crisis in the United States spread throughout the rest of the world, and the entire world faced an economic catastrophe of epic proportions. (Kindleberger)

The depression lasted more than ten years.  There were still 8 million people unemployed in 1940, and the unemployment rate did not fall below 14% until 1941.  It wasn't until 1943—when the economy was fully mobilized for World War II—that the unemployment rate finally fell below its 1929 level, and by then we had increased the size of the military by over 8.5 million soldiers. 

In other words, we did not solve the unemployment problem created by the Great Depression until the government had completely taken over the economic system and had increased the military by more than the number of people who were unemployed in 1940. 

What’s more, the economic system that emerged from our experiences during Great Depression and the war that followed was not the same economic system that had led us into these two great tragedies. 

It was different in at least two fundamental ways.

The Distribution of Income

The first was in the distribution of income.  The concentration of income at the top of the income distribution increased during the 1920s as the share of the total received by the top 1% went from 15% in 1920 to 19.6% by 1928.  It then dropped significantly through 1931 as the crisis unfolded, but it fell below 15% in only one year during the 1930s and averaged 16% for the decade.  

As the government took over the system during the war, the income share at the top fell to 11% by 1945 where it more or less remained until 1950, then dropped to 9% by the end of the Korean War.  It continued to fall throughout the 1950s and 1960s until it reached a low of 7.7% in 1973.

Reforming the System

The second way in which the post-war economic system was fundamentally different from that of 1929 has to do with the way in which the government viewed financial regulation. 

The vast majority of our political leaders, and most renowned economists, entered the 1930s with an abiding faith in the nineteenth-century ideology of free-market capitalism.  They were convinced that markets were self correcting; attempts at government intervention would do more harm than good, and that if the economy was just left to its own devices competition in free markets would allow wages and prices to adjust to bring the economic system back to full employment.  Many, if not most, even believed the economic system would be made better by the experience of a depression in that depressions weeded out economically inefficient firms and, thereby, made the economy more productive. (Kennedy Krugman)

The experience of the 1930s shook these beliefs.  With total output falling by 30%, unemployment at 25%, tens of thousands of business going bankrupt, and human misery increasing at an increasing rate, it was impossible for economists to explain just how the economic system was going to be made better by all of this or why the government should not be allowed to intervene to try do something about it. 

There had to be something wrong with an ideological theory that proclaimed it was good for society to be going through what it was going through at the time.  What’s more, the only explanation the theory could offer for the dismal employment statistics was that wages were not falling fast enough to bring the system back to full employment.  But by 1933, wages had already fallen by 22% in manufacturing, 26% in mining, and 53% in agriculture. 

There was obviously something wrong with the theory.

It was clear to most people at the time, that the cause of the crisis was rampant speculation in the stock market financed by expanding debt.  In fact, the debt created by the financial system during the 1920s had grown to unreasonable levels in all areas, not just in the stock market.  This debt was unsustainable, and the stock market crash was just the trigger that set in motion a set of forces that, in the face of this debt, brought down the entire economic system. 

It was the fear that people and financial institutions would not be able to meet their financial obligations—that they would default on their debts—that led to the panic that brought down the financial system and, ultimately, the rest of the economy following the Crash of 1929.  (Fisher

In 1932 the Senate Committee on Banking and Currency authorized what came to be known as the Pecora Commission to investigate the causes of the developing depression. This commission exposed massive levels of fraud, corruption, conflicts of interest, and incompetence on Wall Street which led to a public outcry for government regulation of the financial sector.  In response, our political leaders of the 1930s through the 1960s abandoned the failed nineteenth century ideology of free-market capitalism in favor of a pragmatic regime of regulated-market capitalism. (Moyers Galbraith)

This led to the creation of an elaborate system of regulatory and supervisory institutions designed to keep our financial system in check.  (Chapter 6)

The Importance of Income and Regulation

It seems to me, that these two fundamental changes in our economic system—the fall in the concentration of income and the rejection of an ideology view of the world that prevented the regulation of our financial system—played a crucial role in creating the economic prosperity that followed World War II. 

The reason is, we live in an age of mass-production technology, and selling the mass quantities of goods and services that can be produced with this technology requires mass markets—that is, markets with large numbers of people with purchasing power.  The requisite purchasing power needed by these large numbers of people can be obtained either from their income or through a transfer of purchasing power from those who have it (and don’t want to purchase newly produced goods and services) to those who don’t have it (and do want to purchase newly produced goods and services)—a transfer that generally takes the form of an increase in debt.

The fall in the concentration of income during and following the war had the effect of increasing the purchasing power out of income for 99% of the population, and, thereby, avoided the need to rely on an increase in debt to provide this increased purchasing power to that 99% of the population.  This, in turn, bolstered the domestic mass markets that fueled our economy following the war, and, in conjunction with the regulatory system that had been put in place in the 1930s, made sustainable economic growth possible without the kinds of speculative bubbles that led to the increase in debt and concentration of income during the 1920s that eventually brought down the economic system in the 1930s.  (Chapter 3)

The result was thirty years of economic prosperity in which the standard of living increased dramatically for almost everyone in this country.

Unreforming the System

Unfortunately, as new generations replaced old, and memories of the 1920s and Great Depression faded, an antigovernment movement began to take hold in the 1970s, and the failed nineteenth century ideology of free-market capitalism—with its mantra of lower taxes, less government, and deregulation—became fashionable again among our economic and political leaders. (Krugman Smith Frank

As a result, the regulatory and supervisory systems that served us so well since the 1930s were systematically dismantled, a process that began, more or less, in the 1970s. 

The pernicious effects of this change in attitude toward regulation became manifest early in the1980s after legislation was passed to relax the restrictions on banks and, in particular, on savings and loans and savings banks. (DIDMC, GSGDI)

The result was an explosion of credit in a number of regional commercial real estate markets.  As the speculative bubbles in these markets burst in the mid to late 1980s we were faced with the first major financial crisis in the United States since 1929.  (FDIC)  In the end, some 1,300 savings institutions failed, along with 1,600 commercial banks, and some 300 fraudulently run savings and loans that were nothing more than Ponzi schemes failed at the peak of this disaster. 

It costs the American taxpayer $130 billion to bail out the depositors in these failed institutions, and the resulting financial crisis was a precursor to the 1990-1991 recession.  (Black FDIC Krugman Akerlof Stewart)

The Rise of Predatory Finance and Corruption

While there were attempts by Congress to reregulate the financial system in the late 1980s and early 1990s, the cat was out of the bag.  The fortunes made by those who had looted the savings and loans during the 1980s clearly demonstrated how a lack of oversight on the part of the government benefited those who were willing to bend or ignore the law.  Even though over a thousand individuals associated with the savings and loan debacle were convicted of felonies, most walked away with their fortunes intact.  (Black Akerlof Stewart)  This was the lesson learned by those at the top of the economic food chain from the Savings and Loan disaster, and this same lesson was drawn from the experiences in other industries as well. 

Throughout the 1980s, fortunes were made through junk bond financing of hostile takeovers and leveraged buyouts that led to the dissolution of American companies, repression of wages, the looting of corporate pension funds and other assets, and the outsourcing of American jobs overseas and to Mexico.  (Stewart Smith)  

Usury laws were repealed, and credit card companies were allowed to charge exorbitant interest rates and fees as they devised elaborate schemes to lure financially unsophisticated customers deeper and deeper into debt.  (PRIG Frontline MSN)

With so much money involved, the lack of government regulation allowed the entire fiduciary structure of our economic and political systems to become corrupted. 

Management salaries and bonuses soared to astronomical levels as the corporate governance broke down, and boards of directors became vassals of their CEOs. 

The major accounting firms found they could make more money advising corporations on how to make paper profits to justify increases in management salaries and bonuses than they could by providing independent audits of companies' books for stockholders. 

Brokerage firms found they could make more money hyping worthless mutual funds and internet, energy, and telecom stocks than they could by providing sound investment advice to their clients. 

Investment banks found it more profitable to dissolve their partnerships, become corporations, and speculate for their own account with investors' money than to provide underwriting and advisory services to their clients.  (Bogle Galbraith Stewart Baker Kuttner Phillips)

The results were huge conflicts of interest—conflicts of interest that contributed directly to the Drexel Burnham Lambert, Charles Keating, Michael Milken, Ivan Boesky, and other insider trading, junk bond, and Savings and Loan frauds that were endemic in the bubbles of the 1980s, the bursting of which were precursor to the 1990-1991 recession

They also contributed directly to the HomeStore/AOL, Enron, Global Crossing, and WorldCom frauds that were part of the dotcom and telecom bubbles of the 1990s, the bursting of which led to the 2001 recession (Chapter 1)

Income and Debt in the Era of Deregulation

The ultimate effect of all of this, just as in the 1920s, was to increase the concentration of income and debt.   By 1990 the income share of the top 1% had reached 13% of total income, a 5 percentage point (or 60%) increase over the 8% it had been in 1980.   At the same time the debt to GDP ratio went from and 170% to 240% of GDP.

By the end of the telecom and dot com bubbles in 2000, the income share at the top had reached 16.5%.  At this point we were back to the level of concentration at which our economic system stagnated throughout the 1930s when there were no speculative bubbles to artificially stimulate the economy.  Meanwhile, the total amount of debt in the economy had increased to 273% of GDP.

Then came the housing bubble of the 2000s.  By the time this bubble had reached its climax in 2007 the concentration of income of the top had increased to 18.3% of total income—just 1.3 percentage points below where it had been in 1928, a year before the Great Crash.  At the same time, debt increased continuously relative to income, reaching to 380% of GDP by 2007, a 107 percentage point increase in just seven years. 

By 2007 the GDP stood at $14 trillion and the total debt that had to be serviced out of that $14 trillion worth of gross income stood at $54 trillion.

This debt to GDP ratio was far beyond anything we had seen in the 1920s which reached its peak at somewhere around 200% of GDP in 1928.  And to make matters worse, due to the systematic dismantling of our regulatory system, the bulk of this debt had been created in the absence of government regulation in a situation in which ideological blindness led officials to believe that it was unnecessary to enforce laws against fraud—that, somehow, self-regulating markets would take care of that little problem without government intervention.  (Krugman Smith)  As a result, fraud grew to unfathomable levels in the subprime and alt-a mortgage markets as the housing bubble spiraled out of control.

It was the fear of default on this fraudulently created debt that ultimately led to the financial crisis in 2007, the crash in 2008, and the world-wide economic depression we are in the midst of today. (Senate FCIC WSFC Spitzer Chapter 4)

The Federal Reserve in the Current Crisis

“What does all of this have to do with The Dynamic Role of Central Banks in the Economy?” I hear you cry.  As I indicated in the beginning, I believe this history helps to explain role played by the Federal Reserve in the financial crisis as well as what I believe to be the fundamental economic problem we face today.

I have nothing but praise for the heroic actions of the Federal Reserve in 2008 and 2009 in expanding its balance sheet as it propped up foreign as well as domestic institutions and kept both the domestic and the international financial systems from imploding.  At the same time, I see the need for these actions as being an indirect result of a failure in domestic policy on the part of the Federal Reserve leading up to the crisis.

The Federal Reserve had the absolute authority, indeed, a duty to regulate the mortgage market under Home Ownership and Equity Protection Act of 1994. (Natter)  Specifically, it had the power to crack down on the fraud that was taking place in this market and to set minimum down payments and other underwriting standards for mortgages, but the ideological faith in free markets to regulate themselves on the part of the officials at the Federal Reserve, in the Clinton and Bush administrations, and in the Congress during the 1990s and 2000s kept the Fed from doing so. (Krugman Smith Chapter 9)  If it had done so there would have been no housing bubble, the financial crisis would have been avoided, and there would have been no need for the Federal Reserve to prop up the world’s financial system in 2008.

It’s worth noting, however, that even if the Fed had regulated the mortgage market and prevented the housing bubble, it would not have solved our economic problem.  The fundamental problem, as I see it, was the adoption of an ideological view of the world that led to the deregulation of our financial system and an increase in the concentration of income. 

The result was a distribution of income that—given the state of technology—did not provide the purchasing power to the large numbers of people needed to sustain our domestic mass markets at the levels required to achieve full employment in the absence of speculative bubbles and unsustainable increases in debt.

Even if the Fed had prevented the speculative bubble in the housing market, and the crisis had been avoided, we would not have achieved economic prosperity.  Given the concentration of income that existed at the time, and that still exists today, the result would have been widespread unemployment if the housing bubble had not been there to stimulate the economy, and there is virtually nothing the Fed could have done to have avoided this result if the Fed had prevented the housing bubble.  (Chapter 3)


In conclusion I would note, it seems to me that if our economic and political leaders fail to come to grips with the concentration of income problem we face today, we are destine to continue to experience the kinds of boom and bust cycles we began in the 1980s where we can only achieve full employment in the midst of a speculative bubble. 

It also seems to me that if we continue along the path set for us by free-market ideologues with their mindless mantra of lower taxes, less government, and deregulation, we will eventually end up right back where we started in the 1930s with the same kind of economic stagnation we experienced back then when we ran out of speculative bubbles to stimulate the economy. 

And finally, if the political and economic leaders throughout the world continue to follow this mindless ideological mantra and refuse to come to grips with the root cause of the worldwide economic catastrophe we face today—namely, the concentration of income at the top of the income distribution—it seems to me that civil unrest is likely to continue to increase throughout the world to the effect that we could eventually end up right back where we ended up in the 1940s. (Ideology Versus Reality)


Appendix: Possible Government Actions to Reduce the Concentration of Income

Some suggested policies to reduce the concentration of income:

1.    Make banking boring again by providing strict reregulation of the financial system to bring the markets for such things as MMMF, repurchase agreements, and financial derivatives under strict regulation and government control.

2.    Strictly enforce laws against fraud in the financial markets.

3.    Breakup the too-big-to-fail financial institutions.

4.    Bring our international current account balance under control. 

5.    Eliminate corporate tax loopholes and increase the income tax by adding additional brackets at the top.

6.    Take the cap off payroll taxes and include unearned income in the base.

7.    Eliminate the special treatment of dividends in the tax code, and if not eliminate the special treatment of capital gains, at least extend the eligibility period for most long-term capital gains to something like five years.

8.    Shift the resources we now put into the war against drugs into a war against tax havens.

9.    Use the increase tax revenues to provide universal early-childhood education, and to subsidize higher education to the point that no qualified student has to go into debt in order to get an education.

10.          Make the WIC program universal for all mothers, infants, and children.

11.          Provide a universal healthcare system that actually works.

12.          Increase the minimum wage.

13.          Start enforcing the laws against unfair labor practices again.

14.          Repeal the so called “right-to-work” provisions of the Taft-Hartley act.

See: Where Did All the Money Go?

HTML hit counter -