“Internal stability and social tranquility are legitimate goals of every society, yours and mine. But along the road there are temptations. It is easy to understand how one country or another can be tempted to shirk its responsibilities to the international community. including the maintenance of monetary order.”
John Connally
May 30, 2024 | During an exchange on X this week, it occurred to us that the deflation building in the commercial real estate sector in the 2020s may be an important parallel to the collapse of the farm sector in the 1920s. The speculative excesses of both periods are different, however, making the comparison imprecise. History does not repeat itself, Mark Twain noted, but it often rhymes.
The engine of our collective downfall, then and now, was the economic rollercoaster operated by the Federal Reserve System. Congress created the Fed on the eve of WWI in 1913, enabling the US to finance allied war purchases. When the war ended, the US was thrown into an economic depression that peaked and then subsided by 1921. Great Britain added to the weight of deflation when it returned to the gold standard in 1925.
Henry Ford shut down his plant in Dearborn for two years in 1927, this to finally transition from the Model T. The Ford plant closure created waves of unemployment around the country and led to the collapse of the Detroit banks in the early 1930s. Deflation on the farm combined with growing speculative excesses in stocks set the stage for disaster, as described by John Kenneth Galbraith in “The Great Crash 1929.” Significantly, as banks fueled stock speculation in the late 1920s, liquidity backing bank deposits plummeted.
By 1927, the heads of the Bank of England, France, and Germany urged the U.S. to lower interest rates. The Fed did cut ST interest rates from 4% to 3.5%. “The greatest and boldest operation ever undertaken by the Federal Reserve System, and…[it] resulted in one of the most costly errors committed by it or any other banking system in the last 75 years!" said Adolf C. Miller, a Federal Reserve Board member who dissented.
When the Fed dropped interest rates a mere half a percentage point in 1927, the resulting swell of speculation led to the collapse of the stock market two years later. The interest rate cut by the Fed in 1927 set the stage for economic disaster. “From that date, according to all the evidence, the situation got completely out of control,” noted Professor Lionel Robbins of the London School of Economics. We recounted the meeting between President Hoover and GM founder (and Elon Musk analog) William Durant in Financial Stability (2014):
"In April of 1929, a yellow taxicab turned into the White House grounds carrying the great Wall Street speculator William Durant, Earl Sparling recounts (Sparling 1930). It was after 9:30 P.M. and the visitor had no appointment. After convincing the staff and the private secretary to President Hoover that the matter was urgent and, indeed, secret, the visitor was shown up to the second floor study. After a while the president appeared and listened to one of Wall Street’s greatest investors warn that the worst financial panic in the history of the republic impended. He cautioned the president that unless the Federal Reserve Board was forced to cease its attempts to curtail brokerage loans and security credit, a crisis was inevitable."
When the Fed increased interest rates in 1928 and 1929 to limit speculation in the stock market, it was already too late. Huge amounts of cash had flowed out of banks into stocks. Thousands of banks would fail between 1929 and 1933. By March 1933 when FDR took office, every bank in the country was closed. As we wrote in "Inflated" (2010) which will be reissued next year:
"On March 4, 1933 President Franklin Roosevelt took office. Most of the nation’s banks were closed and panic ruled the streets of American cities and towns. New York, which held out almost a month after the bank crisis began in Michigan, declared a bank holiday on the morning of Inauguration Day. Terrified citizens were lined up outside New York banks as the new president took his oath of office. Ten days after FDR’s inauguration, he ordered an extended bank holiday. Even as the stronger banks in the nation gradually were allowed to re-open, the banks in Detroit remained closed. Almost a million individuals and businesses in Michigan were cut off from their funds for over a month and the larger depositors of the banks—including Henry Ford—were compelled to wait for the liquidation of the insolvent banks."
Of course, FOMC members don’t dissent very often today. The progressive intellectual monoculture at the Fed does not tolerate much debate, which is largely truncated by the Fed’s staff and the turgid process for adopting the now famous FOMC minutes.
In 1993, when the predecessor to The IRA known as Wires Washington disclosed the existence of the then-secret Fed minutes, they were actually worth reading. Three decades later, Fed minutes just confirm the growing political dysfunction menacing the country. As the chart below illustrates, the Dow Jones Industrial Average has doubled over the past decade, yet FOMC members prattle on about "price stability."
The Fed is pondering an interest rate cut later in the year, this even as the Biden Treasury under Secretary Janet Yellen is funding one quarter of federal spending with debt. If the Fed were actually foolish enough to drop the cost of credit when stocks are hitting new highs and home prices are still rising on the sea of post-COVID liquidity, then we all deserve a financial crisis of equal proportions. Obviously, there should be no interest rate cuts by the FOMC without deficit reduction by Congress.
Here’s how we see the balance of the year unfolding. Markets continue to move sideways as hopes for an interest rate cut are put on hold, but stocks surge higher on the knowledge that inflation is still the real problem. We think the catalyst will be when a near-bank involved in private credit rolls over, causing turmoil in the debt markets. Not a fund involved in credit, but a highly leveraged broker dealer. We'll be discussing the world of private credit in our next Premium Service issue of The IRA. The Fed will respond to problems in the credit markets with new lending facilities, but the contagion will continue to build.
By November 2024, President Donald Trump will have defeated VP Kamala Harris, who presides over the destruction of the Democratic Party at a contested convention in Chicago. President Barack Obama is unable to convince Harris to step aside, leading to an epic political disaster for the Democratic Party. Trump beats Harris by more than 20 points, providing a wonderful historical analog for the defeat of Ambassador John W. Davis and Progressive Senator Robert M. La Follette by Calvin Coolidge in 1924.
Being a progressive institution, the Fed drops interest rates in December as unemployment starts to rise. Several members of the FOMC appointed by President Joe Biden resign to protest the Trump win and make preparations for exile in Canada. Stocks surge along with home prices as the massive inflation in the system floats all manner of financial obligations ever higher.
Even though the Fed only makes one rate cut in December, the additional fuel for the fires of inflation pushes the 10-year Treasury above 5%. Growing numbers of financial institutions are visibly insolvent as LT bond rates rise and CRE losses start to snowball.
By early 2025, as the nation prepares for four more years of managerial chaos under President Donald Trump, bank failures multiply because of the ongoing crisis in commercial real estate and rising mark-to-market losses. Calls for a federal solution to the trillions of dollars in moribund urban real estate fall upon deaf ears in the Trump White House, which instead pushes for the extension of early Trump tax cuts as well as new fiscal “stimulus.”
The new Fed Chairman appointed by President Trump is easily approved by a Republican Senate, which now features a ten-vote majority over Democrats thanks to the Kamala Harris fiasco. The Trump Fed moves to lower ST interest rates and resumes aggressive bond purchases. The Fed’s actions cause an equally large ST surge in debt valuations a la the 1920s that flows into stocks and housing. Home prices gallop higher by double digits on a wave of new lending, pushing the residential housing bubble to record levels but, of note, not really helping either commercial real estate values or consumers.
By the end of the Trump Administration, the federal debt reaches $50 trillion. The Treasury is facing calls from foreign creditors for an IMF-led debt restructuring for the United States. President Trump tells our foreign partners to take a hike, channeling former Treasury Secretary John Connally. After the dollar collapses from its lofty heights, President Trump directs Treasury Secretary Robert Lighthizer to begin negotiations on a debt reduction deal.
The US fiscal crisis causes bond prices to crater and an end to the special role of the dollar. Home prices fall 20-30% back down to 2019 levels, banks and nonbanks alike fail in droves. The great financial reset of 2028 begins as aspirational stocks lose 30 percent of peak valuations. Donald Trump takes a page from his political alter ego, President Andrew Jackson, and returns home to Mar-a-Lago, leaving the nation in financial chaos.
Editor's Note: I am editing "Inflated" How Money & Debt Built the American Dream" for re-issue in 2025 by John Wiley & Sons. The similarities between the 1920s and the 2020s, especially the lack of clarity on economic issues, is striking. Add the absurd federal debt and a global constituency for our fiat dollar. The first rule of any fiat system is no fiscal deficit. The leverage is already baked into the currency. Layers of leverage, the thesis of "Inflated," are dangerous.
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