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The Roots of America’s Financial Crises


Inflated: How Money and Debt Built the American Dream by R. Christopher Whalen (Hoboken, New Jersey: Wiley, 2010); 393 pages.

It is obvious by now that the massive U.S. debt cannot be sustained. Last year’s downgrading by Standard and Poor’s of the U.S. government’s credit rating is but the latest signal that the Obama administration’s policy of an ever-expanding welfare state combined with fighting at least three wars cannot be sustained. Without a substantial reduction in the size and scope of government, it is quite possible to imagine all sorts of frightening scenarios, from a partial or complete repudiation of the national debt to perhaps a bailout by the International Monetary Fund.

But why did this debt crisis happen? Most Future of Freedom readers understand the serious harm that resulted when the United States abandoned the gold standard in 1933 and completely cut all ties to gold in 1971. But as R. Christopher Whalen shows in his authoritative review of American economic history, the drift away from sound money, thrift, and not spending money you don’t have and to the debt-driven economic growth that ultimately led to the current global crisis was the result of nearly two centuries of bad economic decisions.

Whalen is an investment analyst. He formerly worked for Insight and Barron’s and is a good writer. He is the son of Richard Whalen, a prominent conservative commentator and speechwriter of the 1970s, and he cites his father frequently.

Like far too many books these days, Whalen’s book is subject to weak editing. For example, he refers to the current publisher of the Washington Post, Katherine Weymouth, as the granddaughter of Eugene Meyer, who purchased the bankrupt Post in 1933 after serving as chairman of the Federal Reserve Board in the Hoover administration. Weymouth is actually Meyer’s great-granddaughter.

Still, the mistakes in this book are relatively minor. What Whalen reminds us is that nearly every administration, Republican and Democrat, has ultimately pursued policies that moved Americans away from sound money based on gold to a debt-driven economy based on reckless spending and on dollars that have become increasingly flimsy financial instruments.

Regulatory changes

Whalen’s review of two centuries of spiraling debt in America enables him to make prudent comparisons. The “too-big-to-fail” banks bailed out after the 2008 financial crisis, he argues, were equivalent to the debt-laden railways of the late 19th century. In 1893, the Reading Railroad went bankrupt, plunging America into a particularly rough economic depression. The Reading went under because it first borrowed money to expand, then borrowed more money to pay back the loans, then tried to borrow even more money to pay the interest on the second tranche of loans. But because the Reading Railroad’s board of directors was very well connected, the railroad had to be bailed out for the same reasons that the American International Group had to be rewarded for its incompetence by being bailed out — thus concealing “the prevalence of incompetence and outright fraud in the financial world.”

Inflated touches on many topics, and if you’ve forgotten the difference between the First and the Second Bank of the United States, or why the battle in the 1890s over whether or not silver (along with gold) should be the legal tender of the United States matters, Whalen provides a good refresher course. But to my mind the book becomes very interesting when he discusses two disastrous developments that occurred in the first part of the twentieth century — the rising use of debt as a profit instrument for American banks during World War I and the McFadden Act of 1927, which created the Board of Governors of the Federal Reserve Bank and transformed the Federal Reserve from a collection of “reasonably autonomous entities that set interest rate policy within their geographic area” into a centralized agency of the federal government eager to do Franklin Roosevelt’s bidding.

Whalen does not argue that bankers somehow manipulated America into World War I. What he does show is that bankers found that selling the British and French governments’ debt was a lucrative activity, even though that bond selling violated U.S. neutrality. While the bankers didn’t drag America into war, their activities ensured that America was far from a neutral nation. When World War I began, big bankers such as Frank Vanderlip, president of the National City Bank (the ancestor of Citibank) itched to sell the French and British debt, Secretary of State William Jennings Bryan resisted. “Bryan believed correctly,” Whalen writes, “that allowing American banks and investors to underwrite loans for the belligerent powers of Europe would undermine the country’s policy of neutrality.” But Bryan was overruled, and U.S. banks were free to sell the British and French loans from October 1914 onwards.

Once the bankers began to sell debt, they then expanded loopholes to sell more and more British and French war bonds. In April 1915 J.P. Morgan convinced the government to allow the Federal Reserve Banks to accept drafts drawn directly on a London bank, but which had been accepted by a U.S. bank. The bankers then convinced the Federal Reserve Board to allow British and French banks to pay for goods ordered from the United States not with gold, but with paper backed by the promise that somewhere, somehow, there was gold connected to the increasingly dubious paper the Allies were using.

Most Americans didn’t object to those regulatory changes. After all, the Allies were using the bonds to buy American products — food for the troops, shoes for their feet, oil for their tanks and trucks — at high prices. It seemed like America was booming.

But “what is notable about WW I from the view of money, debt, and the American dream,” Whalen writes, “was the easy, almost painless way in which the country accepted the idea of prosperity via borrowing and also a good deal of monetary expansion. The hard-money Jacksonian notions of gold coinage and antipathy to paper issued by banks of any description still lingered in many parts of the country. Yet for a growing number of Americans and the mass of the large business and banking interests, the idea of an aggressive government presence in the credit and commercial markets was entirely acceptable if the end result was prosperity.”

In the 1920s companies tried to come up with new instruments to ensure that Americans bought things they really couldn’t afford. One key development was the creation of the General Motors Acceptance Corporation in 1919, which allowed Americans generous credit on easy terms to buy cars. General Motors in 1920 was the equivalent of a highly speculative dot-com stock. It was seven years old and had already gone bankrupt twice. And America, having had growth artificially fueled by a wartime economy, was in the throes of a severe recession.

So General Motors executives thought up the idea of giving customers easy credit to buy cars. General Motors Acceptance Corporation also provided loans to dealers to carry more cars than they otherwise could afford to stock. The result was that General Motors became the world’s largest car company — but one whose underpinnings were based on the quicksand of debt.

The 1920s, in Whalen’s view, were the time when the American dream changed. Consumers who would spend their lives trying to improve their financial condition through “many years of consistent work, saving, or cash investing” instead saw the path to financial success as one that “depended mostly on luck or avarice, the availability of new credit, or a greater fool to ensure gain or immediate gratification.”

Credit and immediate gratification

In both the 1920s and the first part of the 21st century, Whalen believes, excessive credit ultimately led to periods of economic contraction that were deeper and longer than they otherwise would be. In the 1920s, consumers used mortgages and installment loans to acquire things they couldn’t otherwise afford; in the last decade, far too many of us maxed out our credit cards. Both decades also created complex — and ultimately unsound — financial instruments for selling debt. We all know about the problems of subprime mortgages, but in the 1920s banks repackaged loans to Latin American countries and sold them to investors as bonds. Both the Latin American loans and the subprime mortgages were investment instruments “that were completely opaque and the buyers of these securities usually had no idea about the credit standing of the obligors.”

Another ominous parallel between the 1920s and the last decade was that advocates of strong, central government used the financial crises of the eras to consolidate power. Prior to 1927, the 12 regional Federal Reserve Banks were reasonably independent semi-autonomous entities. The creation of the Board of Governors of the Federal Reserve as a result of the McFadden Act ensured that “the central bank became a permanent fixture in Washington among the other agencies of the federal government.”

As an agency that was under the complete control of the executive branch, the Federal Reserve has largely complied when a president wants to increase the national debt in order to artificially fuel growth. Crucial in the Federal Reserve’s decisions were Franklin Roosevelt’s decision to take America off the gold standard in 1933 and Richard Nixon’s elimination of any connection between the U.S. dollar and gold in 1971. Roosevelt’s anti-gold policies, in Whalen’s view, have had “a more profound impact on the country and the world than many of the dozens of other programs that were put in place during this period,” because the gold decoupling caused the dollar to permanently lose value in the global economy. Nixon’s severing of any connection between dollars and gold, says Whalen, ensured that, in economics, Nixon was a “deficit spending socialist” — as were, to a greater or lesser degree, all of his successors.

To return to economic health, Whalen concludes, America needs to return to frugality, to an era where our country will “limit its wants and needs to our national income.” That means a drastically shrunken government whose primary mission is to pay down the debt created during a century of national profligacy. It also means reconnecting the dollar’s value to gold, and perhaps replacing the dollar as the world’s reserve currency with a combination of the dollar, the Chinese yuan, and the euro. In Inflated, R. Christopher Whalen cogently explains how debt-fueled governmental bloat has led the United States into a financial crisis from which it could take decades to fully recover.

This article originally appeared in the May 2012 edition of Future of Freedom. Subscribe to the print or email version of The Future of Freedom Foundation’s monthly journal, Future of Freedom (previously called Freedom Daily).

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    Martin Morse Wooster, a former editor of the American Enterprise and the Wilson Quarterly, is the author, most recently, of Great Philanthropic Mistakes (Hudson Institute, 2010).