My new book “Bitcoin Nation” was published on the 15th anniversary of the Bitcoin Whitepaper, October 31, 2023. You can read it below, one chapter per week. Or buy it here:
Black Friday, October 25, 1929. The news of the great stock market crash in the USA shocked the world, and a long, deep recession begins. Historians today refer to it as the Great Depression. An economic shock from which the US economy would not recover until the outbreak of World War II. An event of such magnitude that economists still regularly warn against it almost 100 years later. Some even argue that risking a second Weimar hyperinflation is better than another 1929.
The seemingly logical conclusion that central banks and politicians draw from this is that some inflation is necessary. After all, every child knows that 1929 was a “deflationary crash” caused by the inflexible money supply of the gold dollar.
Well, every child also knows that Santa Claus exists. In fact, Santa can probably be better historically substantiated than the connection between hard money and the crash.
A deflationary crash cannot occur in hard money, i.e., one with an almost constant money supply. As we discussed in the previous chapter, price competition between different producers of all goods would have to arise, forcing them to lower their prices to the point of bankruptcy.
Producers would only engage in such price competition in a free market if they could afford it. That is, if one market participant produces more efficiently or believes they can produce more efficiently and make up for losses if they only force enough competitors out of the market.
The likelihood of such competition suddenly developing across all product categories is extremely low. And if it should develop, a large part of the suppliers would go bankrupt after a short time, leaving only the innovative ones to survive. A gain for the consumer.
A deflationary crash requires a fractional reserve system. It is the Wall Street equivalent of a bank run. If stock prices are manipulated upwards with bets on margin and other methods, a hype can arise that even the average person eventually jumps on. Prices soar, more and more people gamble on the stock market instead of working. Companies are incentivized to shift their focus from production and innovation to their stock price. Instead of building reserves and investing, they buy back their own shares.
This leads to stock prices increasingly decoupling from reality until the frenzy eventually fades. The trigger for this sobering realization can be a crisis or just an uncomfortable newspaper report at the wrong time. Suddenly, major investors realize that their portfolio’s nominal value is backed by a tiny real value. They sell, and the price falls. This triggers panic among those investors who only joined to participate in the hype. Like in the game of musical chairs, when the music stops, all investors try to sell their shares quickly, but there are far fewer willing buyers than sellers.
As a result, prices usually crash significantly below the market value justified by productivity, and companies that have borrowed heavily on their shares or depend on liquidity from credit are eliminated.
Such deflationary disasters are typically short-lived. Like the hangover after a night of heavy drinking, there is a brief painful period, and then the economy continues as before. Often even much better than before, as primarily the strongest and most efficient companies have survived the crisis.
A deep, persistent crisis like the Great Depression requires another layer of madness that goes far beyond the price hype frenzy.
At its core, it is a combination of a bank run and a stock market crash.
Leveraged loans, or fractional reserves, allow banks to lend more money than they can cover with their deposits. To not appear over-indebted on the balance sheet, a bank requires collateral from its borrowers.
For example, if you buy a house that costs one million dollars, the bank will lend you a maximum of one million dollars. At the same time, it will demand that the same one million dollars plus interest be registered as the bank’s claim in the land registry. If you can no longer service the loan, your house will be foreclosed, and the bank will receive the portion of your debt plus interest and compound interest from the proceeds. As long as the house can be sold at a sufficiently high price, there is no problem. However, if this is not possible, the bank incurs a loss. The bank cannot reclaim the money you once paid for the house from the previous owner. It circulates in the economy and will perform its function as money many more times. Only the collateral behind it has disappeared.
Let’s now look at the case of leveraged shares: Suppose the fictional company X has a share value of 100 dollars and one million shares in circulation. It borrows 100 million dollars from the bank. The bank adds the 100 million dollars as collateral to the balance sheet and credits X’s account with a balance of 100 million dollars.
This so-called creation of demand deposits is seemingly 100% covered, so it appears to be a full reserve.
What happens when a stock market crash reduces X’s market value to 1 dollar?
Suddenly, the bank has a fractional reserve of a factor of 100. The bank’s balance sheet liabilities of 100 million dollars are now only covered by 1 million dollars in assets.
If this crash occurs in a gold certificate-based currency, it will easily trigger a bank run, as informed investors recognize the bottleneck and quickly exchange their certificates for gold.
If this happens en masse while banks are highly leveraged, the financial system collapses. Banks can no longer redeem the certificates, people lose confidence and hoard gold. This erodes confidence in the demand deposits recorded in the banks’ books even further. A vicious cycle begins.
By hoarding gold, the velocity of money is reduced while the money supply simultaneously shrinks. Considering the Fisher equation, either the number of transactions – i.e., the economy – must shrink, or prices must fall. Usually, both happen.
A crisis becomes particularly severe and prolonged when a central bank or government tries to intervene through regulatory measures, such as distributing subsidies. These interventions prevent creative destruction. Strong companies have to draw on their financial reserves for longer than without intervention, while unprofitable ones are kept alive. Sometimes, innovative and efficient companies are even killed to keep zombie companies going.
This further undermines confidence in the money, driving smart investors even more into gold and tangible assets, leaving the economy with even less covered money. At this point in the cycle, states typically react by banning private ownership of gold, which only exacerbates the problem.
In the case of the United States, the gold ban was enacted in 1933 – four years after the collapse – and lasted until 1974 – three years longer than the gold standard itself.
Strictly speaking, the United States has not overcome the crisis of 1929 to this day, despite the massive war profits from World War II. The gold ban did not help and could only be “lifted” after the petrodollar was established, effectively making the use of any money apart from the uncovered dollar in international trade a capital offense.
Before we go into more detail about the petrodollar, we need to delve deeper into the topic of gold backing, we thus reserve this topic for another book.