Professor Bernanke's Terrifying Blindness

by Michael S. Rozeff

Recently by Michael S. Rozeff: Lunatic Sorcery

With all his scholarly study of the Great Depression, Prof. Bernanke is blind to several truly major factors that caused the Great Depression. His is a blindness that he shares with very many other economists of this day and age. Their condition can be described as “a certain state of mind” that they share that prevents them from seeking out, seeing and saying what is before their eyes. And what is this state of mind? It is to defend the status quo and to stay within the comfortable bounds of conventional beliefs that support the system as it is. This spares them from confronting other institutions and their own.

Because of this state of mind, Bernanke doesn’t see or speak of the common features between the latest banking/real estate fiasco and America’s Great Depression nor, for that matter, features common to most other of America’s economic collapses and depressions. These are fractional-reserve banking, bank financing of real estate and stock speculation, and financial fraud.

By contrast, I point to Prof. Herbert D. Simpson in a 1933 article in The American Economic Review who emphasizes these very banking and real estate factors as bringing on the Great Depression. We now can see that they reappear in the recent past. (Note that my citing Simpson and other articles below means neither an endorsement of everything that the authors posit nor that our own bout of speculation follows the earlier episode precisely.)

Simpson’s article is titled “Real Estate Speculation and the Depression”. He relates that the 1920s was a period of “sensational real estate speculation”. This is a fact that he takes as given, but he merely gives an example:

“In Cook County, outside of Chicago, we had, in 1928, 151,000 improved lots and 335,000 vacant. On the basis of our Regional Plan Commission’s estimates of future population increase, it will take until 1960 to absorb the vacant lots al-ready subdivided in 1928. In fact, on the basis of these computations, we shall still have 25,000 of these vacant lots for sale in the summer of 1960. In one township, Niles Township, we have a population of 9,000, and enough vacant lots for a population of 190,000.”

In support of Simpson, the Baker Library at Harvard writes of “The Forgotten Real Estate Boom of the 1920s“, stating

“The famous stock market bubble of 1925–1929 has been closely analyzed. Less well known, and far less well documented, is the nationwide real estate bubble that began around 1921 and deflated around 1926.”

Most accounts of the 1920s mention this boom, but it has not yet influenced the thought of most modern economists. They prefer other stories, such as that of Friedman and Schwartz, which blames the FED for not inflating. Actually, it did inflate, as Gary North explains. Even though real estate is a sector of economy-wide importance, today’s economists tend to ignore its functioning because of the relative lack of data. Real estate hardly rates an entry in a macroeconomics textbook. They have been also trained to put on blinders and ignore land, ever since neoclassical economics invalidly collapsed land as a factor into capital (see Mason Gaffney for a detailed account.) Furthermore, another part of their state of mind is to think only in terms of aggregate demand, a blanket under which the real estate market and real estate speculation lie submerged and hidden.

For recent support for Simpson, there is the 2010 paper by William Goetzmann and Frank Newman titled “Securitization in the 1920′s“. The latter study backs up Simpson’s conclusion that there had been rampant real estate speculation. Goetzmann and Newman write

“The present crisis is not the first time that the real estate securities market has expanded to the brink of collapse. The U.S. real estate securities market was remarkably complex through the first few decades of the twentieth century. Many parallels with the modern market can be observed. The early real estate development industry fed the first retail appetite for real estate securities. Consequently, easily obtainable financing via public capital markets corresponded with an urban construction boom…Ultimately, the size, scope and complexity of the 1920s real estate market undermined its merits, causing a crash not unlike the one underpinning our current financial crisis.”

The mention of an “urban construction boom” by this study is what Simpson mentions in his paper 79 years earlier:

“Our latest speculative movement differs from all previous speculative eras in the United States in the fact that it has been distinctly an urban field of speculation, …”

Another recent article that compares the 1920s to the present is Eugene White’s “Lessons from the Great American Real Estate Boom and Bust of the 1920s”:

“Although long obscured by the Great Depression, the nationwide ‘bubble’ that appeared in the early 1920s and burst in 1926 was similar in magnitude to the recent real estate boom and bust. Fundamentals, including a post-war construction catch-up, low interest rates and a ‘Greenspan put,’ helped to ignite the boom in the twenties, but alternative monetary policies would have only dampened not eliminated it. Both booms were accompanied by securitization, a reduction in lending standards, and weaker supervision. Yet, the bust in the twenties, which drove up foreclosures, did not induce a collapse of the banking system. The elements absent in the 1920s were federal deposit insurance, the ‘Too Big To Fail’ doctrine, and federal policies to increase mortgages to higher risk homeowners. This comparison suggests that these factors combined to induce increased risk-taking that was crucial to the eruption of the recent and worst financial crisis since the Great Depression.”

White is correct that deposit insurance, too big to fail, and federal policies have made the present situation worse than the 1920s, other things equal.

A pervasive 1920s real estate boom or bubble is consistent with the Austrian analysis in which the banking system produces fiduciary money, lowers interest rates, and flows it into assets of long duration whose values are particularly sensitive to interest rate fluctuations.

Simpson’s analysis weaves several threads together into one fabric. The central thread is fractional-reserve banks that finance long-term assets with short-term deposits:

“Now, when it is recalled that these were not mortgage banks, organized on principles of long-term financing, investing their own capital funds, and free from deposit liabilities, but that they ordinarily purported to be commercial banks, engaged in accumulating and carrying large deposits, and that their operations were financed largely through the funds of their depositors, it will be realized in what a highly over-extended position this segment of our banking system was placed.”

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