The Accounting System #11: The Great Unraveling of 1930

previous: #10, The Federal Reserve and Accounting Money

In short, in 1930 the economic system unraveled because of the way it was built. The previous upward spiral of increasing economic activity was enabled by the ability of the banking system to expand both deposits and loans. Over time, however, many people had withdrawn deposits from banks to buy stocks, while others took loans from banks that were used to buy stocks. When stock prices started dropping (because enough people had realized it was a fool's game), people could no longer easily take money out of the market like they could take it out of a bank deposit. For loans to be repaid more stocks needed to be sold, and when stocks became relatively worthless, deposits had to be drained to make loan payments or for ordinary expenses. Loans and deposits, accounting money, disappeared rapidly, even when there was plenty of cash to facilitate cash transactions.

At the end stage banks could not collect on loans (because so many people had lost their jobs), and so had to use reserves to pay depositors who wanted to make withdrawals. When reserves were gone, the accounting rules said the banks had to close. There was no deposit insurance, so accounting money in the form of deposits, simply disappeared. Suddenly self-accounting with cash seemed like a better idea than bank accounting with numbers in ledgers.

We are largely trained to forget that there was one large, industrialized nation whose economy did not collapse in the 1930s. In the U.S.S.R. (essentially Russia) there was no stock market to collapse, and state banks and most of the economy were all government-owned. The government had total control of the accounting system. Despite the other defects (even atrocities) of the Communist system, there was a realization that money, the economy, and accounting were all human creations, and it was possible to run a command economy with some success (although command economies also have very high failure rates. It mostly depends on the commanders).

The New Deal can be fairly said to replace the free market economy of the United States by a command economy supervised by the government. In the end it took the increased demand created by World War II to get the American economy on its feet, and the legacy of the New Deal was not a command economy but a re-engineered free market economy.  Some of the changes had little to do with the accounting system, but two made noteworthy changes.

While most of the bubble in stock market prices was simple human folly, there was also fraudulent accounting at some corporations that was used to jack up stock prices. The SEC (Securities and Exchange Commission) was created in 1934 to attempt to insure that investments traded in public markets were neither fraudulent or manipulated. Among other reforms, the accounting of individual listed corporations now had to be audited by a (hopefully) independent auditor, and reported to all investors at least quarterly in a standardized format. Their accountants and their auditors were giving accounting rules they had to follow, Generally Accepted Accounting Principles (GAAP). This standardization of the accounting system meant that any person, not just accountants, could learn to read and understand any American business accounting statement.

The creation of the Social Security system would have long-term repercussions far beyond what was originally envisioned. Because many Americans were alive who had the same name, each person who paid into or received money from the system was given a Social Security Number.  Later this number would come to be used as a national, individual identity number, thus vastly enlarging the domain of The Accounting System.

Next: #12 Electronic Money Takes Over

[The Accounting System, Your Fate is in the Cloud, is a work in progress by William P. Meyers, ©2013]

#8. Eureka: Reserve Banking

previous: #7: Virtualization in Early Banking

Consider a small city served by a single banker-merchant. He has built a safe room to store coins and has a clerk to keep accounts. He has lent out all his own money and, it being a prosperous era, in the past his loans have always been paid back on time and with interest. There are all these coins, really a lot of the coins of this city, sitting in his safe. He can't help thinking that if he could lend them out not only could he earn interest on them, but it would be good for the community. One client wanted a loan for a second fishing boat, which would surely be paid back, since the demand for fresh fish is high. The banker thinks of other clients who would be helped if only he could make loans to them.

Then it strikes him! Like a jolt of lighting, like a burning bush, like Christ speaking to him from the crucifix of the local church. Every day a client or two comes in and deposits or withdraws money. Over time the pile of coins has grown. On no one day do enough clients come in to withdraw all the coins. Eureka! He calls his clerk Big Data and says: go back through the ledgers and find out what the lowest count of coins we've had on deposit in the last five years.

A week later Big Data says: in the last five years we have never had less than 4,000 gold coins on deposit. And how many are on deposit today, our banker asks. 5,282, says Big Data. The banker sends out his clerk to get another blank accounting book.

The new account will record loans to clients that are made using the coin in client deposits. The fisherman borrows 50 coins to buy a new boat. He takes it to the boat builder, who is worried about having 50 gold coins sitting in his workshop or house. So … he takes the coins to the banker and deposits them. The banker will make, perhaps, two gold coins in interest on the loan. The same number of coins are back in the safe as there were at the start. The two gold coins paid in interest along with the original fifty are not even new coins. They are from the banker's stash of depositors' coins. The fisherman has a new boat, the boat builder a small profit, the men who cut timber for the boat have made wages, and the banker is richer.

The banker sees that the system is a closed loop. Most of the coins he loans out come back as deposits. As long as the town is prospering, as long as the total goods owned and services provided continue to grow (as they did in many Italian towns during this period, until the Turks cut off the trade routes to the East and the Portuguese and Spaniards gained monopolies in the West), the Banker can loan out the same coins over and over again. Sometimes coins are traded to outside his loop, but other times coins come in trade from other regions. The coins left in the vault, the ones that are not loaned out because they may be demanded by their owners, are what we call a reserve.

The accounting system is now critical to the banker's success. He has to know who owes him principle and interest, as well as how much he owes depositors. He sees that while he does not have coins to pay all the depositors at once, he does have loans out that will cover the deposits.

Of course, sooner or later, the banker will find that due to a series of withdrawals, he is running out of coins. He knows he'll be okay over time because the loans are still good, and he expects them to be paid in coin. Perhaps his friend who started as a fisherman comes in wanting to make a large withdrawal of coins that will break the bank.

The banker enquires why such a large sum of money is required. The depositor is buying an estate so that he can retire from managing his fishing fleet, leaving it to his son, and enjoy life as the owner of a country estate known for its fine grapes and wines. It so happens that the current possessor of the estate, Luciano,  has borrowed a sizable sum from the bank. The banker suggests that it is dangerous to carry such large sums around. He can facilitate the transaction by giving Luciano a note cancelling his debt along with the coin needed to make up the difference. The fisherman accepts this, and the bank is saved.

Of course in reality the system evolved over time and with many participants, but the idea of the reserve system was a major extension of the accounting system and the beginning of the end for coins. Over the centuries large numbers of banks have failed, some because of fraud but most because they did not keep sufficient reserves. It happened to a few American banks last year and it will happen again next year, and continue as long as the system is used. But on the whole the system of keeping small reserves of coin, and later paper money, and now electronic money, to back a larger accounting of loans and deposits, has worked rather well.

Next: #9: Virtualization with Checking and Credit Cards

[The Accounting System, Your Fate is in the Cloud, is a work in progress by William P. Meyers, ©2013]

Could Greek Socialism Kill Global Capitalism?

Could Greece kill global capitalism?

Industrial workers were not a very important segment of our global society in 1800. People who toiled for an employer at something other farming had been around from at least the beginning of written history. At certain places and times had been significant portions of a local population. But even in Great Britain in 1800 most people had a close connection to agricultural production. Most industrial production had to do with refining agricultural products like milling grain or spinning cotton and wool.

By 1850 Britain was an industrial power and men like Mikhail Bakunin and Carl Marx had worked out ideologies that gave what they called the industrial proletariat a center-stage role. The villains were industrial capitalists, in their view. A series of political revolutions began that, at least ostensibly, tried to put the working class in control of society. There was a limited degree of success, with the Russian communist revolution and Chinese communist revolutions being the best known, and milder forms of socialism (leaving parts of capitalism intact) being much more widely adopted.

A funny thing happened on the way to utopia. The communists tried to out-industrialize the capitalists, and in some ways succeeded. In a sense the state bureaucrats simply became substitutes for the capitalist class.

The biggest threat to capitalism, it seemed in the 20th century, was capitalism itself. The Great Depression caused even our capitalist heartland, the United States of America, to adopt some socialist measures like social security, unemployment insurance, and a progressive income tax structure.

In the 1980s and 1990s the trend was to undo socialism, with Presidents Ronald Reagan and Bill Clinton presiding over the process in the U.S. The economic disasters of the first decade of the 21st century followed.

Capitalism showed its resilience as an economic, political, and social structure in the 20th century. But that does not mean it is indestructible. I don't think it is about to self-destruct, but it is instructive to look at how close it is to self-destruction today.

The economy of Greece is more socialist than capitalist, but not particularly more so than the typical European nation. Usuallytempering capitalism with socialism has made for the most economically vibrant societies (which of course, are also the most ecologically destructive societies). But Greece, in its global context, shows how capitalism and socialism can still be mutually destructive at times. Perhaps more destructive than ever before.

The Greek economy borrowed money from foreign economies. Just like if you or I borrow money, it is not necessarily a bad thing. Whether borrowing is good or bad depends on what you borrow the money for, how much interest you pay on the loan, and your ability to repay the interest and principle. If you borrow from Tony Soprano at 20% per week and put the money on a horse, or up your nose, most people would agree that is bad borrowing. On the other hand, if you get lucky and your horse wins the race, it makes the loan appear to be better in retrospect than it would be considered in general. A good loan example might be borrowing money at 4% a year, resulting in some obvious benefit, like lowering your cost of living if your mortgage payments are less than your old rental payments, or being able to hire more workers and make more profit if the loan is used to buy crucial machinery for your business.

The Greek loans were somewhere in between, but leaning towards the Soprano model. On a national scale the loans allowed civil servants (who make up over a quarter of the work force) to retire early with cushy pensions. That sounds lovely, but the problem is the world is becoming more competitive, not less. Greeks in general, and civil servants in particular, need to work more years, and longer hours, to justify their consumption levels. Those who loaned to Greece were the greater fools.

In politics politicians want to please people. Capitalist and socialist, Republican and Democrat and independent alike. If you don't please enough people, you don't get re-elected, and if you don't allow elections, you may get overthrown. Pleasing people means keeping taxes as low as possible relative to benefits. So almost every government borrows money. If economies grow, the tax base grows, and the loans can be paid off with relatively little pain.

But economies can grow in different ways. If they grow by everyone consuming more without producing more goods or services, they are going to get in trouble, no matter what the socialist to capitalist mix.

Capitalists of the banker sort want to loan money. It is nice clean work. They want to believe that loans will be paid back. It makes everyone happy.

Greece and the United States have much in common. The main difference is not the socialism to capitalism mix, though that should not be discounted. The main difference is that America borrows money mainly for military expenses.

Would you lend money to Tony Soprano? How would you get it back if he decided not to pay? All you could do learn from your folly, and resolve to not loan to him ever again.

Loaning money to the United States, especially to the federal government, is beginning to look suspiciously like loaning money to Tony Soprano. I think the Chinese and Japanese are fools to do it. So are American investors.

I don't think the Greek crisis in itself will kill global capitalism, but it is a warning. Socialism, originally, was supposed to be for all the workers, not just government workers. Capitalism was supposed to be about the wise deployment of capital. But mix the worst of both together, as has happened in the U.S. and in Greece, and you have a truly toxic brew.