Thursday, October 23, 2008

Bernanke, Gold, & the Great Depression

I came across this article today while looking for historical gold data. http://www.federalreserve.gov/boarddocs/speeches/2004/200403022/default.htm

It is a pre-Fed Ben Bernanke talking about the effects of certain policies undertaken by the President and the Federal Reserve during the Great Depression. I found myself seeing his arguments having some rational backing however, he never arrived at the cause of the Depression.

His disdain for the gold standard is quite obvious:

"The finding that the time at which a country left the gold standard is the key determinant of the severity of its depression and the timing of its recovery has been shown to hold for literally dozens of countries, including developing countries. This intriguing result not only provides additional evidence for the importance of monetary factors in the Depression, it also explains why the timing of recovery from the Depression differed across countries."

Earlier in the speech, Bernanke spoke highly of the gold standard, saying that in the period of 1870 to 1914 (Pre Federal Reserve), the gold standard worked very well. He noted that World War I created problems for countries financing the war. These countries eliminated the gold standard and swapped it for fiat money. The effects of this policy was hyperinflation. When these countries tried to return to the gold standard, they found it difficult because of their depleted gold reserves, huge post war debt, and excessive inflation. Therefore, they were forced to devalue currencies.

This should send a signal to monetary policy makers. Do not get into wars, limit spending, and do not run huge deficits if you want to maintain the value of your currency. However, the banking system of today is rewarded for inflating the money supply. By inflating the money supply, banks are able to lower the risk of default on their loans. Why? Because as nominal incomes and housing (or any other asset lent against) prices rise, the debt service coverage on those loans rises (income to debt payment). Banks tend to make their money on the front end through fees and the first few years of interest payments. With this and the low reserve requirement banks can make returns on equity above 25% per year.

If prices become too inflated and the debt to asset price ratio or debt service coverage ratio falls too much, it is an indicator that prices will begin to fall or adjust to the amount of money in the system. This is simple economics, excess money raises prices, but if there is nowhere to put the money to earn a return then it will sit on the sidelines until there is a place to earn a return.

The problem occurs when banks are dependent on rising prices to lower the debt coverage ratios on their loans. Financially mismanaged banks have low reserves and low debt coverage ratios on their loans. If one of these banks becomes insolvent or experiences a bank run, the assets they once had drop in value or drop to zero value. Depositors lose their money, unless it is insured and the capital base of the nation drops. This is the problem with a credit based versus a gold based monetary system. Credit is based on faith which is difficult to quantify and is very fragile since it is based solely on human emotion, gold is based on a hard asset that is tangible and can be quantified.

What Bernanke did not get into in the article was the cause of the Great Depression, i.e. excess credit pumped into the money supply, therefore devaluing the currency, and setting the country up for a massive correction. The gold backing the dollars was not enough to support the over 3:1 ratio of debt to GDP. Debt coverage fell making it difficult for investors to earn a favorable risk adjusted return. Since banks bet on rising asset prices as a result of the credit based system, once capital owners saw that it would not be prudent to make debt-based purchases, the banks started to see their loans begin to default. Depositors lost faith in the credit system, and withdrew their money. Eventually debt:GDP corrected to an almost 1:1 ratio, only after misguided plans by FDR to prop up asset prices.

Bernanke addressed the outcomes of the inevitable deflation of the dollar, but did not address the causes. How a man of intellect could skim over the causes of the depression, and could become the man to lead our monetary policy during this time as the head of the Federal Reserve is beyond me. He could have learned a lesson in my grad school statistics class. Correlation does not imply causation.

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