Where Did All The Money Go?
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Because of the way the current economic crisis came into being, it is
unlikely our financial institutions will be able to intermediate between
borrowers and lenders to revive the economy anytime soon. The only way they
can do this is through a substantial increase in non-federal debt, and it is
virtually impossible for financial institutions to increase non-federal debt
in the absence of investment opportunities, real or imagined, to justify the
Given our experiences with imaginary investment opportunities over the past
thirty-five years, and the disastrous consequences that followed the
housing bubble bursting, it is unlikely we
will be able to rely on yet another stock-market or real-estate bubble to
provide yet another temporary solution to our employment problem. And since
the effects of the concentration of income and current account deficits on
our domestic mass markets have diminished the real investment opportunities
available to us, we are not likely to get out of the hole we have dug
ourselves into through yet another substantial increase in non-federal debt.
This is especially so given the non-federal debt ratio equal to 278% of GDP
that existed at the end of 2013.
At the same time, there is no reason to believe we can revive the economy by
purging the system of debt through the
conservative monetary and
fiscal policies of restraining the Federal
Reserve and cutting government budgets. That certainly didn’t work in the
shows the relationship between GDP and Debt from 1929 through
Historical Statistics of the U.S. (Cj872),
Bureau of Economic Analysis (1.1.5).
As Non-Federal Debt fell from $175 billion in 1929 to $144 billion in
1933, GDP fell from $105 billion to $57 billion. Thus, in the process
of purging $31 billion worth of Non-Federal Debt from the system,
GDP fell by $47 billion. The end result was a 18% fall in Non-Federal
Debt accompanied by a 45% fall in GDP as the ratio of
Non-Federal Debt to GDP went from 168% of GDP to 252% of
GDP. And as has been noted, in the meantime, over
10,000 banks and savings institutions failed
129,000 other businesses; the unemployment
rate soared to
25% of the labor force as
12 million people found themselves unemployed
by the time this purging of debt came to an end.
The purging of debt from 1929 through 1933 led us into the depths of the
Great Depression, and it is instructive to
examine just how we got there.
shows the implicit GDP Deflator along with the Money Supply
and the Monetary Base and
Reserves from 1929 through 1941.
Figure 11.2: Money and Prices, 1929-1941.
Bureau of Economic Analysis, (1.1.5
Economic Report of the President 1960 (D40
As is shown in this figure, the demand for currency outside of banks
was unchanged in 1929 and 1930 as Currency in Circulation remained at
$3.6 billion in both of those years. It then increased by $900 million in
1931 as the banking crisis that began in October of 1930 took hold, and
Currency in Circulation increased by an additional $200 million in 1932.
By the time the run on the banking system ended in 1933 Currency in
Circulation stood at $4.8 billion and had increased by a total of $1.2
billion since 1930.
This 33% increase in demand for currency outside of banks was met by an
increase in the Monetary Base that followed a similar pattern as the
increase in the demand for currency, but with a lag. The Monetary Base
remained unchanged at $6.0 billion in 1929 and 1930, increased by $844
million in 1931, actually fell by $9 million in the midst of the banking
crisis in 1932 as Member-Bank Reserves fell by $200 million. The
Monetary Base then increased by $329 million and stood at $7.1
billion in 1933.
This lag in the increase in the Monetary Base on the part of the
Federal Reserve, combined with the overall timidity of its response to the
crisis, allowed Member-Bank Reserves to fall by $265 million from
1930 through 1932. Faced with the economic downturn, the run on the
system, falling reserves, and falling asset prices, banks struggled to stay
liquid and maintain their solvency by refusing to make new loans or renew
existing loans. The result was a fall in the money supply as Currency +
All Deposits fell by 22% from 1929 through 1933 (from $54.7 billion to
$42.6 billion) while Currency + Demand Deposits fell by 25% (from
$26.4 billion to $19.8 billion). (Fisher
In turn, the process by which this contraction of the money supply took
place had a devastating effect on prices in general as businesses were
forced to mark down their inventories and sell them off at a loss. It also
had a devastating effect on wages as employers found it impossible to
maintain the level of wages they had previously been able to pay as the
prices at which they were able to sell the goods and services they produced
fell. The deflation that resulted from 1929 through 1933 as the Federal
Reserve sat back and allowed the system to purge its debt is shown in
Figure 11.2 by the 26% fall in the GDP Deflator from 118.6 in
1929 to 88.0 in 1933.
shows Federal Outlays, Receipts, and Surpluses
from 1929 through 1941 along with the Unemployment Rate and the
output of goods and services as given by Real GDP measured in 1937
Figure 11.3: The Federal Budget and Unemployment,
Bureau of Economic Analysis, (3.2
Economic Report of the President, 1967 (B20).
As is shown in this figure, federal government expenditures increased by 48%
from 1929 through 1931, fell by 26% in 1932, then increased by 17% in 1933.
In the meantime, Real GDP (measured in 1937 prices) fell from $88.2
billion to $65.0 billion—a 26.3% decrease in the output of goods and
services produced. When this fall in output was combined with the 25.8% fall
in prices shown in Figure 11.2 it brought about a 45.3% fall in
GDP. As a result, the increase in federal Outlays from $2.8
billion in 1929 to $3.7 billion in 1933 was accompanied by a fall in federal
Receipts from $3.7 billion to $2.6 billion, and the budget went from
an $800 million Surplus in 1929 to a $1.1 billion deficit (negative
Surplus) in 1933.
Thus, while Non-Federal Debt (Figure 11.1) decreased by $31.2
billion during this period, this decrease was partially offset by a $7.8
billion increase in Federal Debt as tax Receipts fell and
emergency Outlays increased. At the same time, GDP fell from
$104 billion in 1929 to $57 billion in 1933 as the Total Debt ratio
went from 183% to 295% of GDP and, as was noted above, the
Non-Federal Debt ratio increased from 168% to 252% of GDP.
In the end, a net $23 billion of debt was purged from the system by forcing
debtors to liquidate their assets or to default on their debts—a net
reduction equal to just 22% of Total Debt. In the process of purging
this debt, the Total Debt to GDP ratio—and along with it, the burden
of servicing the remaining debt—went through the roof as this ratio
increased by 111 percentage points to 283% of GDP and the
Non-Federal Debt ratio increase by 84 percentage points to 252% of
GDP. At the same time, gross income (i.e., nominal GDP) fell by
45% and output (i.e., Real GDP) by 26%, and it is worth emphasizing
again that along the way over
10,000 banks and savings institutions
failed along with
129,000 other businesses; the
Unemployment Rate soared to
25% of the labor force, and
12 million people found themselves
unemployed by the time this purging of debt came to an end.
It wasn’t until after the Federal Reserve allowed the Monetary
Base to increase dramatically following 1933 in a way that allowed banks
to increase their Excess Reserves dramatically—from virtually zero
($60 million) in 1931 to $770 million in 1933 to $1.8 billion in 1934 and to
$3.0 billion in 1935—that the purging of debt came to an end. And it wasn’t
until after Federal Outlays had increased to 5.1% of
GDP and the government’s budget had gone from a Surplus equal to
0.8% of GDP in 1929 to a deficit (negative Surplus) of 3.7% of GDP in
1934 that debt stopped falling and the Unemployment Rate began to
fall as GDP began to increase.
In other words, the debt problem that was created in the 1920s was not
resolved by forcing debt to be purged from the system through
conservative monetary and
fiscal policies. These policies, in fact,
devastated the economy from 1929 through 1933, and this devastation did not
come to an end until:
The Federal Reserve expanded the Monetary Base dramatically
and provided the Excess Reserves needed by the banking system to end
the implosion of the financial system that took place from 1929 through
The federal government increased its Outlays dramatically and,
thereby, increased the aggregate demand for goods and services and made it
possible for the economic system to grow.
Even then it took the
1933 bank holiday in which all the banks were
forced to close and then reopened with a
deposit guarantee on the part of the federal government
before the carnage caused by the downward spiral of Debt, GDP,
and employment was brought to an end.
Yet another important lesson from the 1930s—a lesson that has particular
relevance today—can be drawn from the effects of the change in government
policy following 1936 as the federal government attempted to balance its
budget by cutting its expenditures and the Federal Reserve attempted to
eliminate the excess reserves in the banking system by increasing
The expansion of government expenditures and the monetary base that began in
1934 led to a 43.1% increase in Output (from $65 billion to $93
billion measured in 1937 prices) and a 42.6% fall in the Unemployment
Rate (from 24.9% to 14.3%) by 1937. At that point the expansion came to
an end as we returned to the
conservative monetary and
fiscal policies that had proved so disastrous
from 1929 through 1933. In the process we managed to reduce Excess
Reserves in the banking system by 68% in 1937 and to nearly balance the
federal budget in 1938, but at the cost of a jump in the Unemployment
14.3% of the labor force in 1937 to
19.0% in 1938 as the output of goods and
services (Real GDP) fell by 3.2%, and the Federal Debt to
GDP ratio went from 42.2% in 1937 to 46.3% in 1939.
In other words, when the federal government cut its expenditures in 1937
and the Federal Reserve tried to eliminate the excess reserves in the
banking system the economic recovery ended and the economy slipped back into
a recession. The economic system did not recover from this shock until
the federal government and Federal Reserve reversed these policies and
government Outlays and Excess Reserves began to increase again
after 1938. It is exceedingly difficult to understand just how the benefits
gained from this exercise in
conservative monetary and
fiscal policy, whatever those benefits might
have been, justified these costs.
There are at least three fundamental lessons we should have learned from our
experiences during the Great Depression.
The first lesson we should have learned is that implementing
conservative monetary and
fiscal policies that purge non-federal debt
from the system by forcing debtors to liquidate their assets or default on
their financial obligations in the face of an economic downturn is not a
good idea. Such policies drove the system into a downward spiral from 1929
through 1933, a downward spiral that did not come to an end until these
policies came to an end. The importance of this lesson is reinforced by the
fact that when these self-defeating, conservative policies were resumed
following 1936, the economic recovery that had begun in 1933 came to an end,
and we experienced yet another downward spiral in 1938 that didn’t come to
an end until these policies were abandoned for a second time.
It is also worth noting that the deleveraging in the economy that we see in
Figure 11.1 as Total Debt ratio fell from 295% of GDP
in 1933 to 163% by 1941 resulted from an increase in GDP, not from a
decrease in Debt. Total Debt increased from $168 billion in
1933 to $211 billion in 1941 while Non-Federal Debt increased from
$144 billion to $155. At the same time GDP went from $57 billion to
$129 billion. Clearly, it was the increase in GDP that was
facilitated by the expansionary monetary policy and increase in government
Outlays that led to the decrease in the debt ratio following 1933,
not a fall in Debt brought about by
conservative monetary and
A Timid Response Does Not Work
Another lesson that should have been learned from the 1930s is that a timid
response on the part of the government to increase the monetary base and
government expenditures in the face of a financial crisis is not enough.
This lesson should have been made clear by the fact that the unemployment
rate never fell below
14% during the Great Depression and, as we
saw in Chapter 3, the unemployment problem was not completely overcome until
the federal government began to mobilize for World II. It was only after the
conservative monetary policy and budget balancing fiscal policy were
completely abandoned and the government began to expand dramatically at the
beginning of our involvement in World War II that government expenditures
and the monetary base expanded enough to solve the unemployment problem
caused by the Great Depression.
The government takeover of the economy during World War II was, of course,
far beyond what was actually needed to solve the unemployment problem
created by the Great Depression, but our experience during World War II
clearly demonstrated that the government did, in fact, have the power to
solve this problem through its monetary and fiscal policies. The tragedy was
that it wasn't until World War II that the government actually used these
tools effectively to solve this problem.
Increasing Taxes Stabilizes the Budget
Finally, one of the most important lessons that should have been learned
from the 1930s, and one that has particular relevance today, is that in
bringing about the recovery from the downward spiral of income, output, and
employment in the 1930s the federal government did not resort to
squandering its fiscal resources on worthless tax cuts and transfers to the
upper echelons of the society who were able to use the proceeds to purchase
the government bonds needed to finance the tax cuts and transfers.
The increases in government expenditures following 1933 were funded, in
at least nine tax increases that took place
during the Great Depression, starting with the
Revenue Act of 1932. In so doing the federal
government was able to provide the stimulus effects of its increases in
expenditures in a fiscally responsible way as it partially financed these
increases by increasing taxes. To the extent these tax increases fell on
those who were unwilling to spend, this minimized the negative effect of tax
increases on spending while, at the same time, mitigated the effect of the
increases in government expenditures on the national debt and, hence,
reduced the transfer burden from taxpayers to government bondholders that
results from the need to pay interest on the national debt.
As a result, even though the increase in government expenditures in the
1930s was insufficient to bring the economic system back to full employment,
because of the tax increases that had taken place the federal debt ratio
stood at 42% of GDP in 1937, just as it had in 1933, in spite of the
oversize deficits that had occurred over the preceding four years—deficits
that managed to facilitate a 43% increase in output along with a 43% fall in
the rate of unemployment.
When we look at what
happened during World War II we find that the federal debt was not
stabilized as federal expenditures rose to over
40% of GDP. But, as we saw in Chapter 3, the
tax structure put in place during the war—which, to a large extent, remained
in place for twenty years after the war—made it possible to reduce the
federal debt to GDP ratio below its 1940 level by 1962. It was the increase
in tax rates preceding and during the war that remained in place following
the war that made this kind of federal debt stabilization possible.
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Where Did All The Money Go?
How Lower Taxes, Less Government, and Deregulation Redistribute Income and
Create Economic Instability
It should be noted that the tax
increases of the 1930s did not always follow this rule and would have
had less of a negative effect on demand if the tax increases had been
concentrated on those who were unwilling to spend. See