Leverage E-Book

Karl Denninger

• Herausgeber: John Wiley & Sons
• Kategorie: Fachliteratur
• Sprache: Englisch

Seitenzahl: 339

Veröffentlichungsjahr: 2011

Beschreibung

How the wealthy and powerful abuse finance to skim immense profits Debasement of the dollar as a result of ill-use of leverage is destroying the global economy, and in Leverage, well known market commentator Karl Denninger follows the path of money throughout history to prove that currencies are debased when moneyed and powerful interests pull the levers of government and policy to enrich themselves at the expense of the masses. The result is ugly: the value of everything--including gold--falls, and even personal safety is at risk in a world where there is limited money even for essentials like food and fuel. History is littered with the collapse of monetary and economic systems from Rome to Germany to Zimbabwe. * Presents an inside look at how moneyed and powerful interests debase the dollar through the willful and intentional failure to honestly represent short and long-term mathematical truths that underlie all economic systems * Shows how, if imbalances are not corrected, financial crises will reoccur again and again * Authored by Karl Denninger, who has been running the popular website The Market Ticker since 2007

Leseprobe

Table of Contents

Cover

Title page

Copyright page

Dedication

Epigraph

Foreword

Acknowledgments

Introduction

Part One: LEVERAGE AND ITS ABUSES IN THE ECONOMY

Chapter 1 An Economic Future for America

Chapter 2 Principles of Financial Leverage

Chapter 3 The Aughts or the Aught-Not-Haves

Chapter 4 The Failure of Kicking the Can

Part Two: A WAY FORWARD

Chapter 5 The Folly of Avoidance

Chapter 6 Reinstating the Rule of Law

Chapter 7 Reforming the Fed, Lending, and Derivatives

Chapter 8 Fixing Social Security, Pensions, and Health Care

Chapter 9 Structural Fixes for Trade, Taxation, and Federalism

Chapter 10 Devising a Sound Energy Policy

Conclusion

About the Author

Index

Copyright © 2012 by Karl Denninger. All rights reserved.

Published by John Wiley & Sons, Inc., Hoboken, New Jersey.

Published simultaneously in Canada.

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Library of Congress Cataloging-in-Publication Data:

Denninger, Karl, 1963–

 Leverage: how cheap money will destroy the world / Karl Denninger.

p. cm.

 Includes bibliographical references and index.

 ISBN 978-1-118-12284-6 (cloth); ISBN 978-1-118-16614-7 (ebk); ISBN 978-1-118-16615-4 (ebk); ISBN 978-1-118-16616-1 (ebk)

 1. Financial leverage. 2. Debt. I. Title.

 HG4521.D487 2012

 332–dc23

2011025473

ISBN 978-1-118-12284-6

Leverage is dedicated to my daughter Sarah, who will inherit the nation we leave her and her future family.

As we peer into society’s future, we—you and I, and our government—must avoid the impulse to live only for today, plundering for our own ease and convenience the precious resources of tomorrow. We cannot mortgage the material assets of our grandchildren without risking the loss also of their political and spiritual heritage. We want democracy to survive for all generations to come, not to become the insolvent phantom of tomorrow.

—Dwight D. Eisenhower

Foreword

When you start experiencing severe chest pains, dizziness, and nausea, do you want the doctor to tell you, “Don’t worry—you’re fit as a fiddle, and everything’s going to be fine”—or do you want the truth?

If you want a future, then you want the truth.

This is why Karl Denninger’s The Market Ticker blog has long been a must-read for those who want a positive future for their children and their nation: he reports the truth.

The symptoms of systemic failure are painfully evident, but most Americans don’t want to see the elephant sitting on the chest of the United States of America: leveraged debt, the so-called cheap money that will destroy our nation. Leveraged debt is crushing our households, enterprises, and government, yet such is the level of ignorance and fear that wishful thinking and false reassurances dominate the public dialogue.

The only way forward is to start with a truthful accounting of our financial illness, and that is precisely what this book serves up, with the same clear explanations and charts that have drawn those hungry for facts to Karl’s blog.

If you want another serving of empty promises, media doublespeak, official obfuscation, or blatant self-interest masquerading as policy, you’ve come to the wrong place: Karl is absolutely fearless when dispatching the sacred cows that have gridlocked the national debate.

What you will get is a fact-based diagnosis of our ills and a nonideological presentation of practical solutions. The goal here is nothing less than the restoration of the real economy over the financialized FIRE (finance, insurance, real estate) economy based on leveraged debt and a poisonous culture of fraud, embezzlement, collusion, and crony capitalism.

We seem to have lost our social and institutional memory of a healthy, transparent financial sector that doesn’t rely on leverage, misrepresented risk, and bogus accounting to reap profits, and of a time when the financial sector did not dominate the real economy and the political process.

As Karl makes clear in these pages, the stakes couldn’t be higher; the reliance on leverage has fatally undermined the U.S. economy, and the outsized political influence purchased by the financial sector’s vast profiteering threatens our democracy.

This reliance on leverage and sleight-of-hand accounting has also undermined our ability to make fact-based assessments; rather than demand an honest appraisal that might threaten the status quo, we’ve allowed ourselves to be lulled into self-deceptive denial. This book is a wake-up call for everyone who puts their country and future generations of Americans ahead of their own self-interest.

In the public sphere, patriotism has been cheapened by an epidemic of single-minded self-interest to empty slogans and empty gestures, as if wearing an American flag lapel pin covered up the raw greed and self-interest behind the typical appeal to “the national interest.” Karl challenges all Americans to examine the financial facts of the matter, and in so doing, set aside their own claims on future taxpayers in favor of fixing what’s broken.

The great appeal of Karl’s message is its depiction in simple-to-understand charts of our multiple financial illnesses, and its fearlessly direct appraisal of what we need to do to restore our economy and nation to health. Having a profoundly honest conversation about our ills and our options of treatment is the only way forward, and this book exemplifies the leadership we need: not the dishonest pandering of our political class, but instead speaking truthfully about the changes and sacrifices that must be made to restore the nation and its future. We don’t have to agree on every point, but we do need to begin the conversation. This book shows us where to start.

Charles Hugh Smith

Author of An Unconventional Guide to Investing

in Troubled Times and www.oftwominds.com

Acknowledgments

I would like to thank the whole host of people without whom my drive to analyze the economic matters discussed here would not have been possible. Chief among them is my father, who was a CPA for a modest glass company during my youth and who both introduced me to the basics of bookkeeping and provided me with my first opportunity to program a computer for money at age 13. I doubt he had any idea where letting his son fix a tax table in an old bookkeeping machine would lead.

The early 2007 Asian market swoon deserves thanks for jolting me awake from what had been a very simple and profitable trading career for the previous four years. Also, the user community that developed around my web publication, The Market Ticker, provided encouragement for me to undertake the wider view of our economy and markets that you will find in these pages.

Finally, I’d like to thank both Janet Tavakoli, for her introduction to John Wiley & Sons, and the staff at Wiley themselves for their support in preparation and editing. Without them, Leverage would not have come to fruition.

Introduction

Leverage.

A simple word, really. When you use a bottle opener to uncap your favorite brew, you use leverage. When you pry open a can of paint with a screwdriver, you use leverage. And yet in the financial world, abuse of leverage has repeatedly led the economy to ruin.

Leverage is simply the trade-off of one element of motion or action for another. With the can of paint, your screwdriver has a quarter inch of movement at the business end under the lip, but four inches of movement on the handle. You thus multiply the force you exert by 16 times, but the trade-off is that the bit moves only a 16th as far.

With financial leverage, the same principle applies, except the trade-off is that losses multiply, exactly as do gains. Nearly everyone who undertakes a leveraged transaction understands this part of the essence of leverage.

But what’s not thought about often is the inherent nature of leverage in the financial realm and how, as a consequence of the fundamentals of finance that go back over a thousand years, certain mathematical facts cannot be avoided.

It is, in fact, attempting to avoid the expression of these facts that leads to the worst financial panics and depressions.

It is my hope that this book will provide a unique perspective on these foundations of our financial life. None of this should need to be written down. These facts remain undiscussed in the financial media, and it would be fair to assume that even people like Federal Reserve Chairman Ben Bernanke don’t understand the basic mathematics that underlay all financial systems.

Such an assumption would be terribly foolish, for it is only through the public’s lack of knowledge that banking and financial interests can fleece our nation and, indeed, the people of all nations. If every American understood the facts I lay on the table in this book, there would have been no Internet bubble, no housing bubble, and no crisis of confidence in the financial system in 2008 and 2009.

What is discussed here is no less fundamental than the sun rising in the east each day and setting in the west. Without understanding these foundational principles, one cannot craft public policy to both accept what we cannot change and yet have outcomes that are acceptable for all actors in the financial system, both public and private.

One may argue with a mathematician, but one may not argue with the math itself.

Part One: LEVERAGE AND ITS ABUSES IN THE ECONOMY

Chapter 1

An Economic Future for America

Through the ages, the principle of financial leverage has been both used by the many and abused by the wealthy and powerful in society. The seduction of leverage is strong, in that it makes the difficult appear easy and the impossible seem to be within reach. It brings the illusion of equality between the wealthy man and the common laborer in the land of finance.

You can think of leverage as a drug, and an addictive one at that. Like many drugs, leverage is perfectly acceptable when used in moderation. But as with all addictive things, leverage has a lure that is indescribable once it is tasted. Who among us who has bought a house doesn’t remember the first time we inserted the key in our new-to-us home and walked through the front door? The house is devoid of furniture and fashion, a box into which we would load our lives, and we quickly forget that we don’t really own the house since a bank has the legal right to our title. The new car smell is likewise one that people consider a rite of passage, even though that smell is probably a derivative of formaldehyde and rather unhealthy!

The seduction of having a little plastic card in your wallet that can buy the equivalent of a car in seconds with no money in the bank is powerful. Many have walked into a shopping mall and an hour or two later emerged with thousands of dollars’ worth of clothing, jewelry, perfumes, and baubles that they have no idea how they’re going to pay for. Indeed, how many of us didn’t chuckle to some degree at the comedy Confessions of a Shopaholic on the silver screen and failed to identify, in some small way, with the pithy phrase “Really declined.”

In the financial panic of 2007 to 2009, who could fail to note that certain wealthy and powerful people seem to have not only escaped the wrath of contraction in the economy and credit but also profited tremendously from these events? Others of apparent wealth and many of modest means have been rendered destitute. Millions of jobs disappeared, salaries and wages were slashed, and as of early 2011, more than a million homes have been lost to foreclosure.

Some have put forward the theory that certain people of money and influence have the ability to sway events to their liking through various forms of bribery, whether legal or not, with regulators and members of government. Still others believe that luck is responsible for the difference in outcomes. Neither view is correct.

Some wealthy people do indeed use their influence with government officials and even resort to actions that could be called extortion when the economy turns downward. Influence peddling, bribery, and threats are as old as politics itself, and it should not surprise anyone that the rich and powerful are at the center of these activities when their wealth is threatened.

To stop the abuses of leverage in our financial markets, we must first identify the fundamental nature of leverage and how structures are set up to disadvantage the general public. The abuse of these structures requires that the average person be ignorant of the fundamental nature of capital. They must not understand how capital and leverage, otherwise known as debt, are fungible, and how certain mathematical facts guarantee outcomes over time in the economy as a whole. This lack of knowledge among the populace is then exploited by the few in positions of power to set up edifices that strip the general population of their wealth, much like a whale is flensed after being harpooned, leaving the public in debt peonage. Eventually these artificial structures always collapse, exactly as they did during the California Gold Rush. The collapse leaves wealthy only those who exploited the bubble to skim off a piece of the activity via selling blue jeans, picks, and shovels, while the majority of others who engaged in the Ponzi scheme are bereft of both a job and their allegedly accumulated wealth.

Only through an understanding of history, along with the fundamental nature of leverage in the economy, can we change the economic system to end these abuses. While there are many who argue that the market is efficient and left to its own devices will govern these matters on its own, the presence of governments and thus the inevitable corruption that comes with them makes this option entirely unsatisfactory. There are choices available to us, and we as a body politic can choose to demand their implementation.

Should we fail to address these imbalances, there will be dire consequences for the United States and indeed the entire world economic system. We can no longer pretend that the Federal Reserve holds the power to address what’s wrong with an economy that is structurally defective, just as we cannot fix a collapsing bridge by painting new lines to divide the lanes of traffic and claim that the structure has been rehabilitated.

Consider America’s future, where your children and grandchildren will live their lives. What will it look like from an economic perspective?

If you look at the U.S. labor market today, you see more than 30 years of exporting manufacturing jobs overseas. The first exodus was to Japan, which destroyed the U.S. television and automobile industries. The second was to China, which destroyed large swaths of high-tech manufacturing and assembly. While the United States has maintained manufacturing output, it has come almost exclusively through mechanization and productivity gains; manufacturing employment has plunged by half since 1979 and stands at roughly 11.5 million as of March 2011, despite the population increasing by almost 50 percent during the same time period.1 The alleged economic recovery from 2009 onward has come with more than three-quarters of all the jobs created paying below $15 an hour, well under the national average hourly wage of $22.50.

In 2011, we have crushing levels of federal, state, and local debt, and more than a third of all so-called wage income is paid by some form of entitlement program, whether it be Social Security, welfare, Section 8 housing, or food stamps. One in six households cannot afford to buy food in America, a 58 percent increase in three years’ time.2 Our civilian population employment rate, the percentage of adults who are in the workforce, is back to where it was before women joined the workforce en masse in the 1970s. Contrary to economic projections in 2000 that the federal government would be debt-free by 2010, our federal debt more than doubled from $5.7 trillion to nearly $15 trillion, and the unfunded mandates in Social Security, Medicare, and Medicaid total approximately $100 trillion. Our total indebtedness and obligations are roughly seven times the total economic output of the United States. In April 2011, Secretary of the Treasury Timothy Geithner threatened to raid federal employee retirement funds if Congress refused to allow the Treasury to borrow even more money.3

The future one can see ahead on the path we currently walk is bleak.

What if you were to learn that there is a path forward that will produce a better tomorrow? Would you insist on changes today that would bring prosperity back to the United States, even if those changes would produce severe short-term economic discomfort?

We can have a nation and economy that manufactures most of what we consume at home. The United States can have abundant and stable energy supplies. We can have a stable, sound banking system that matches lenders and borrowers, along with clearing payments, but does not encourage speculation. We can have sound money with no inflation over decades-long periods of time. We can have a college system where your children can afford to put themselves through school working part-time, taking on no debt, with only a small contribution from you as their parents. And we can have medical care that delivers excellent outcomes without bankrupting you, your employer, and our society as a whole.

With a labor force that is vibrant and earns wages in the United States producing cars, televisions, computers, and more, our middle class can afford to buy the goods and services they produce. Credit will be uncommonly used in the population, reserved for true emergencies and extraordinary events instead of being a staple of everyday life. Interest payments will be small and uncommon. Speculators will be free to place their bets, but they won’t be able to demand handouts when they lose in the Wall Street casino. You will be able to save 10 percent of your gross income during your working years and, coupled with a Social Security system that remains solvent, live out your life without having to speculate in the stock market. A house will be a place where you hang your hat instead of a get-rich-quick scheme that blows up in your face and results in foreclosure, eviction, and financial destitution.

Some Americans will choose to start businesses and employ others. Those who do will not fear having their product’s design ripped off in China and sold without compensation or fear that their competitor will utilize slave labor and environmental pollution as a strategy to put them out of business. The rest of the United States, who work for someone else, will compete against other first-world nations and their citizens for jobs rather than against near-literal slave labor being paid $2 a day.

We hear constantly about income inequality in the United States, but there are two forms of income inequality, and one of them is positive for the nation. The rich person who becomes wealthy by inventing a new process or widget brings wealth to everyone. Henry Ford made possible ownership of an automobile by virtually every man who worked for him on the assembly line. To deny him the wealth that flowed from his innovation would be to prevent the production of the Model T, and America would have been much poorer. But some people become wealthy by finding ways to effectively screw the public, putting in place legal and business systems that skim off funds without providing anything of real value in return. Our focus should be not on flattening income inequality but rather on getting rid of the economic and legal structures that allow and protect theft while encouraging competition and entrepreneurship. We should encourage many Henry Fords and Thomas Edisons in our society rather than those who use financial trickery as a means of enriching themselves at the expense of the public.

Tax systems that are designed for social agendas provide a convenient foil for those who would demagogue political issues for their own ends, and the United States suffers greatly for it. Our tax code has become part of an intentionally convoluted economic structure that is designed to consign the common man to debt peonage and poverty. Why else would we tax long-term capital gains, the fruit of a successful investment that employs others, while at the same time allowing a tax deduction for interest on consumed capital goods, particularly housing, which can only make you poorer?

The United States emerged from World War II as an economic powerhouse unequaled before in the world. Where we produced tanks and aircraft for war, we turned to peaceful production of automobiles and airliners. Where we produced radar screens, we changed those factories over to produce televisions. Where we produced nuclear weapons that ended the war, we turned our ability toward peaceful nuclear power and currently obtain 20 percent of our electricity from exploitation of the atom.

We can return to our former status as an economic powerhouse without equal. America lost its way not because there are other nations with a better political structure, a smarter population, or more resources than we possess. We stumbled and fell through a common path of corruption called leverage that has played out time and time again through history. The salve found in leverage is much like alcohol; the first drink does no harm and makes you feel good. The tenth has you in the bathroom hugging porcelain. If you do not learn from your mistakes and continue to increase your consumption, rather than choosing to be a teetotaler, you will eventually suffer liver cancer or alcohol poisoning and die.

You have taken the first step on the path of understanding how the United States, like so many other nations, lost its way. But unlike many other books through the years, here you will also find how we can regain the path of prosperity.

The choices before us are not simple ones, but they are necessary. Our path toward destruction did not happen in an afternoon, a month, or a year. We have been destroying our nation through debt alcoholism for more than three decades, and recovery will take time. There will be setbacks and pain, as there always is when breaking an addiction. Our focus as a nation must be not on the binge of today but rather on how we sustain our economy and people through both today’s generation and tomorrow’s.

Every journey to set right what has been wrong begins with a first step. Before we embark on our journey of reconstruction, we must understand how we both broke our nation and became broke so we can avoid the traps that were intentionally set by those who corrupted our future. Without understanding the foibles of the past, we have no hope of avoiding them tomorrow. Those who profit mightily from the current economic structure in which we find ourselves trapped will not easily give up the privilege they have won through decades of trickery and deceit. It is only through understanding why the alleged solutions they put forward cannot work that we, the people of this nation, can challenge and depose their bankrupt economic prescriptions, replacing them with sound alternatives.

America’s future down one road is dark and foreboding, while down the other, it is vibrant and exciting. We stand at a fork in the road, and our challenge is to choose the path that looks rockier at the outset, but leads onward and upward toward sunshine and a warm summer’s breeze rather than downward to ruin.

Notes

1. Bureau of Labor Statistics, Table B-1 series as of March 2011.

2. USDA SNAP Report, Annual Household Participation as of March 31, 2011.

3. Sean Riley, “Treasury May Borrow Federal Retirement Funds in Debt Emergency,” Federal Times, April 5, 2011, www.federaltimes.com/article/20110405/BENEFITS02/104050306/1001.

Chapter 2

Principles of Financial Leverage

Capital and leverage are inextricably intertwined. Capital is a single word that denotes the fruits of one’s labor that have been reduced into an easily exchanged form and frequently manifests in what we call money. Idle capital is a mere store of wealth, but when put to work, it builds businesses, employs workers, and generates productivity throughout the economy.

Leverage is simply the use of debt to replace capital in a transaction. Both leverage and capital spend in the economy in exactly the same way, just as a credit card in your wallet spends exactly the same as does a $20 bill. When it is recognized as the functional equivalent of capital, it is easy to see how leverage can become addictive, as it allows a person, corporation, or government to act as if they have amassed much capital, when in fact they have little or none at all.

In the general sense, there are four types of capital utilization that can be undertaken in the economy. Three of them are conveniently called investments. The four categories of capital utilization and the relative risk involved in using leverage to replace the capital used are:

1. Productive Investment. This is best exemplified by the purchase of a machine that makes widgets, which are then sold to customers. The machine has a cost, and with the input of raw materials, labor, and energy, that machine produces an output that the investor hopes has more value in the marketplace than the sum of the input costs. Combined with adroit management and utilization, use of capital in this manner produces a net positive return to the economy as a whole. The risk of loss lies in the miscalculation of the final value of the products or services produced by the machine, in that there is never a guarantee that whatever comes out of the machine will sell for more than the sum of the expenses. This use of capital is routinely able to be profitably financed using leverage for both the borrower and lender.

2. Speculative Investment. This is best exemplified by the direct purchase at an initial public offering (IPO) or other direct offering of capital stock in a corporation that produces goods or services. Such a company must, of course, be able to produce a positive cash flow against operating expenses, including debt service. The use of capital itself produces no inherent return; however, through the exploitation of the capital gained by the seller of the investment, a net positive rate of return can be obtained. The level of indirection—that is, reliance on a third party for performance and the possibility that the borrower will spend the funds instead of productively investing them—inherently increases the risk involved in using one’s capital in this fashion. This type of capital use, when financed through leverage in whole or part, is potentially dangerous because the carrying cost of the debt is additive to the acquisition expense, and the investor lacks direct control over the ultimate use of the borrowed funds.

3. Consumption. This category, as opposed to the others, is not thought of as an investment at all but rather is the dissipation of capital for the purpose of enjoyment of one’s life. Some of the consumption we undertake is involuntary; our basic needs such as food and some degree of clothing and energy use are physical necessities of life without which we will literally expire. Housing properly falls into this category; but in the 2000s, housing was moved downward one step with disastrous results. When viewed as a durable good, housing, like transportation, is thought of as an item that has declining natural value due to its maintenance expense. This use of capital is dangerous to engage in using leverage because in addition to pulling forward tomorrow’s demand into today, you are adding the financing cost to the total price you will pay, and the asset in question is ultimately consumed.

4. Ponzi scheme. A use of capital is properly considered a Ponzi scheme if the only way the purchased item can increase in value is by locating someone who will pay a higher price. While Ponzi schemes are often called investments, they in fact never are. Housing is one such category when viewed not as a place to live in or rent out to someone else but rather as an item you acquire for capital appreciation. To generate continual growth of such an asset’s value, either you must generate continually advancing demand or you must find some way to make purchasing your asset easier so as to be able to justify a higher price. The same principle holds true for the purchase of stock on an exchange for capital appreciation rather than dividend income. This use of capital is inherently unstable and, when compound growth occurs, poses extreme risk of eventual price collapse when the next buyer fails to materialize. Leverage, otherwise known as debt, should never be used to buy into any Ponzi scheme. If your timing is wrong and the next sucker fails to appear, the leverage you have taken on is immediately exposed. The risk of bankruptcy in such a situation is extremely high since not only can you lose your original investment but also the borrowed funds may be lost.

Economic panics and depressions throughout history have typically been generated as a direct consequence of people shifting their use of leverage toward consumption and Ponzi schemes to a greater and greater degree, and away from productive investment. As these shifts begin, the illusion of free money becomes common in the general population. Stories are printed in the media and circulate around the dinner table of persons who have put in little or no capital of their own yet are living like kings and enjoying the trappings of luxury, all by borrowing to allegedly invest.

The seduction of inexpensive debt and the apparent riches that can be skimmed off through its use is difficult to resist. The earliest recorded bubble in common literature is probably the tulip mania1 that took place during 1636 and 1637 in Holland. The price of various exotic tulip bulbs underwent a more than 20:1 increase over the space of just a few months, although few if any actual deliveries of bulbs took place. Instead, the Dutch traded contracts remarkably similar to our modern-day futures in that they allowed one to purchase a bulb today for delivery at a future date, paying only a small transaction fee. There were no margin requirements or any supervision of the ability to pay the full contracted price, however, and as a result, only through finding another purported investor willing to buy your contract could you turn your paper contractual gain into actual money.

When the price of tulips collapsed in the early months of 1637, those who held the contracts were left with an obligation to buy a bulb at many times its current market value. The government responded to the incipient destruction of many people’s wealth by changing the law in February 1637, allowing those who were stuck with these contracts to get out of them by paying a small penalty. Tulip mania is thus not only the first speculative bubble but also the first recorded bailout for those who got caught up in a Ponzi scheme and would have otherwise been financially ruined.

Following the U.S. Civil War, there was a boom in railroad construction. More than 50,000 miles of track were laid between 1866 and 1873, enabled by government land grants. Speculative capital underlay much of the construction, even though at the time there was no proven demand for the rail lines that were to operate once the track was finished. Modern finance and computers did not exist, of course, but traditional bond-style funding was plentiful and inexpensive. A huge number of bond issues were sold to the public not only for the construction of railroads themselves but also to finance construction of ports, stations, and terminals associated with the new rail lines. These new rail lines and associated projects had been funded not with saved capital but rather with what looked at the time to be extremely cheap debt, as the expected profits to be earned by these rail lines danced in investors’ imaginations. Mechanization of U.S. farms following the Civil War also contributed to the boom, as the cost of farming in the United States fell more rapidly than in Europe, making U.S. farm products more competitive in European nations.

In 1871, Germany decided to move away from its use of silver as a monetary metal. This depressed demand for silver, much of which was mined in the western United States to which these rail lines had been extended. The United States responded to falling silver demand by dropping its silver coinage backing as well, moving to an effective gold-only monetary standard in 1873 through the Coinage Act.2 The impact of this law was dramatic in that in addition to causing the price of silver to drop further, it called into question the stability of U.S. monetary policy. Longer-term bond obligations fell into immediate disfavor, as inexpensive long-term bond financing is inextricably tied to the expectation of stable monetary value. Being a highly durable sort of investment, railroad bonds had typically been of long duration, and many investors had borrowed to purchase them. The value of their holdings declined precipitously, calling into question their solvency. Jay Cook and Company, a major banking interest that was funding what was to become the Northern Pacific Railway, failed to close on a $300 million government loan after reports circulated that their credit was exhausted due to the decline in long-duration bond values. The firm collapsed.

A chain-reaction set of bank failures followed, and the New York Stock Exchange was closed for 10 days to attempt to sort out the mess left by companies that suddenly found themselves with rapidly deteriorating bond positions that they had counted as allegedly safe capital. The speculative mania that had driven the issuance of debt for the funding of these railroads collapsed with dramatic force, and layoffs rippled through factories and rail lines. Unemployment reached 14 percent, and a quarter of the nation’s railroads went bankrupt over the next three years. Subsequent strikes by railroad labor unions in 1877 to protest layoffs and falling wages led President Hayes to send federal troops in an attempt to break the strikes. More than 100 strikers were killed in the skirmishes that followed.

The Panic of 1873 required six years of deflation and debt destruction before the financial imbalances that had been built up in the previous seven years were cleared from the economy. 3

Everyone has read about the 1929 stock market crash and the Roaring Twenties. What’s not commonly written about is what made the 1920s roar. It was cheap leverage, or debt, that was once again behind the speculative craze. In addition to a wave of industrialization and advances in technology, the first use of leverage to buy household appliances and homes was thrust into the mainstream. Land speculation with risky mortgages was rampant, especially in Florida. As prices rapidly increased, the balloon mortgage, where one paid only interest on the loan for a period of a few years, with the entire principal due at the end of the term, became the primary means of real estate purchase nationwide. Stocks were bought with leverage as well, with brokerage houses allowing the purchase of $10 worth of stock with only $1 of actual capital on deposit. The Dow Jones stock index rose from 64 in 1921 to a high of 383 in 1929, a nearly 500 percent increase in eight years.

Those who were paying attention noticed in late 1925 that land prices in Florida had stopped rising. A few newspapers and magazines ran articles warning that prices were being driven solely by the expectation of finding a buyer at a higher price. Panic quickly set in, as speculators who had bought property with nothing more than a letter of credit began to have trouble finding new buyers and were called on to perform on loans they never believed they would have to pay. A pair of hurricanes in 1926 and 1928 destroyed infrastructure in the southern half of the state and left the Florida property market in ruins, but most investors believed the property collapse was local to the state and was not a consequence of severe economic imbalances that had become embedded throughout the nation. They were wrong.

From 1927 onward, arguably in an attempt to blunt the impact of the Florida property collapse, pundits and politicians made statements that were later proved wildly inaccurate. It can be argued that these statements were nothing more than intentional attempts to keep confidence high on what was known to be a bubble about to burst. Among them were the following quotes from people of particular note:

We will not have any more crashes in our time.

—John Maynard Keynes in 1927

There may be a recession in stock prices, but not anything in the nature of a crash.

—Irving Fisher, leading U.S. economist, New York Times, September 5, 1929

The October 1929 stock market crash brought into stark relief the folly of leveraged speculation. With only 10 percent down required by brokers, the crash destroyed many investors overnight as their margin was immediately wiped out. The paper gains they had been counting as real wealth evaporated, and the resulting margin calls could not be met. Homes and land that had been purchased on balloon notes with the expectation that a refinance would always be possible were lost to foreclosure as the value of property fell and the owner could not make the balloon payment or refinance into another product. The government attempted to stem the liquidation of massive bad debt with both direct action and speeches that cast the economic future in a favorable light, including statements like the following:

This crash is not going to have much effect on business.

—Arthur Reynolds, Chairman of Continental Illinois Bank of Chicago, October 24, 1929

I see nothing in the present situation that is either menacing or warrants pessimism. … I have every confidence that there will be a revival of activity in the spring, and that during this coming year the country will make steady progress.

—Andrew W. Mellon, U.S. Secretary of the Treasury, December 31, 1929

I am convinced that through these measures we have reestablished confidence.

—President Herbert Hoover, December 1929

Nothing of the sort, of course, was true.

The Great Depression was only great due to its length; from a standpoint of economic contraction in a brief period of time, both the 1873 and 1920 downturns were far more violent. Ending only when the United States entered World War II, the Great Depression featured forced currency devaluation, the establishment of an artificial market for home loans in the form of Fannie Mae,4 confiscation of privately held gold,5 the intentional destruction of crops by the Roosevelt administration in an attempt to prevent crop price deflation,6 and more. All were attempts to prevent the market from clearing out speculative excess that had been embedded in the form of leverage, and all were unsuccessful for the simple fact that the economy had built into itself levels of production for which there was no demand that could be paid for with current output. When the pyramid of leverage collapsed, there was nobody to buy these products and services, businesses were bankrupted, and unemployment became rampant.