LIQUIDITY PROBLEMS – 1929
In 1928 and 1929, the Fed raised interest rates for the purpose of curbing rampant speculation in stocks. At that time, investors could borrow as much as 90% of the stock price for their proposed investment. The banks were just as aggressive as investors and were happy to oblige.
Raising rates did not slow stock speculation by investors or banks, however.
What it did do was cause a slowdown in economic activity. Thus, as economic activity declined, the stock market continued its rise, unabated.
As the decline in economic activity continued, both businesses and consumers were affected negatively. The money was available for investors to buy more stocks, albeit at a higher cost; but, businesses and consumers struggled with liquidity problems.
STOCK BUBBLE BURSTS
The crash in the stock market brought illiquidity issues to light. Layoffs in the financial industry were numerous and swift. The ranks of the unemployed ballooned.
If you were an investor who had purchased stock with 10% down, it would take only a 20% decline for you to have lost twice as much as your original investment.
Now, imagine the plight of the banks who had lent money to investors using stocks as collateral. The collateral was worth as much as 30% less after one day of trading. Bank failures became almost commonplace during the Great Depression that followed.
FED RESPONSE
As might be expected, the Fed did purchase government securities in the open market and lowered the discount rate. It also assured commercial banks that it would supply needed reserves.
Unfortunately, “too little; too late” became the common descriptive phrase used when referring to Federal Reserve response to the crisis which it had caused. That is because the economic devastation was overwhelming.
Unemployment soared to as much as 25% and prices declined (deflation) by more than one-third. The aggressive, free-spending social programs of the 1930s government could not stop the slide and contributed to the length and breadth of the depression. At the depths of the Great Depression in 1932, the stock market had declined by 90%.
The stock market crash was not the cause of the Great Depression, though. The Great Depression was caused by a Fed policy of higher interest rates. Whatever the intention or merits of the action (the higher rates were imposed for the purpose of curbing rampant stock speculation), it led to a reduction in economic activity which was well underway before stocks crashed.
INFLATION, DEFLATION, AND THE FED
The Federal Reserve officially implemented an interest rate policy of “higher for longer” almost three years ago. Rates moved up rapidly and bond prices have lost one-third to one-half of their value since then, depending on length of maturity. (see “And So Rates Will Be Higher” – Jerome Powell)
It matters not what the intention was or whether it was correct. What matters at this point are the circumstances in which the Fed finds itself now.
Most, or all, of our serious financial and economic problems are the result of a century of intentional inflation. The effects of that inflation lead to a loss of purchasing power in the currency (U.S. dollar). When the Fed intervenes in the markets either directly (by purchasing or selling securities) or indirectly (manipulating interest rates), it creates distortions which have ripple effects and are amplified.
In addition, those effects are unknown with regards to extent, duration, and timing. Remember being surprised at the higher increases in consumer prices post-Covid and economic shutdown. Those increases are attributable to government (and central banks) actions in response to the ‘pandemic’.
The economic shutdown was forced upon society by government – rightly or wrongly. As a result, the decline in economic activity led to huge financial and economic problems for society, including supply chain issues. These problems were met with phenomenally huge financial largesse (inflation) by governments and central banks, which, in turn, led to higher consumer prices (effects of inflation).
After more than one hundred years of trial and error, it is apparent that…
- The Federal Reserve causes the problems and crises with which it continues to grapple.
- The Fed is doomed to a role of reacting to crises of varying intensity (worse) and frequency (more often).
- Serious deflation and economic depression would overwhelm efforts by government to reverse the effects or contain the damage.
CONCLUSION
There is no path to financial stability from the current point that does not involve a cleansing of huge magnitude. The cleansing will be accompanied by serious financial and economic pain. The Fed is continually dancing with its own devils amid music which is horribly out of tune. The only option left is to wait until the music stops. (also see If The Markets Turn Quickly, How Bad Can Things Get? )
Kelsey Williams is the author of two books: INFLATION, WHAT IT IS, WHAT IT ISN’T, AND WHO’S RESPONSIBLE FOR IT and ALL HAIL THE FED