1

THE REVISIONIST THEORY AND HISTORY

OF DEPRESSIONS

Antal E. Fekete*

San Francisco School of Economics

aefekete@hotmail.com

An accounting principle, the Law of Liabilities, asserts that a firm ought to carry its

liabilities in the balance sheet at its value upon maturity, or at liquidation value,

whichever is higher. This Law has been ignored by present accounting standards, which

has been the cause of massive deflations and depressions through the destruction of

capital, and the rise of the liquidation value of debt, in the wake of monetary policy

making the rate of interest fall.

The Book-Keeper’s Dilemma

One of the plays of George Bernard Shaw branded “unpleasant” by the playwright himself is

entitled The Doctor’s Dilemma. The protagonist is a physician who comes into conflict with

the Oath of Hippocrates (fl. 460-377 B.C.) He has developed a new treatment for a fatal

disease, but the number of volunteers for the test-run exceeds the number of beds in his clinic.

Unwittingly, the doctor finds himself in the role of playing God as he decides who shall live

and who shall die.

By the same token a “most unpleasant” play could be written entitled The Book-

Keeper’s Dilemma. The protagonist, a chartered accountant, finds himself in conflict with the

letter and spirit of book-keeping as set out by Luca Pacioli (fl. 1450-1509). As a result of

compromising the high standards of the accounting profession, the book-keeper becomes the

destroyer of Western Civilization. This play is, in effect, being written by history right now.

Finest product of the human brain

Luca Pacioli taught mathematics at all the well-known universities of Quattrocento Italy

including that of Perugia, Napoli, Milan, Florence, Rome, and Venice. In 1494 he published

his Summa Arithmetica, Tractatus 11 of which is a textbook on book-keeping. The author

————————————

* This is an up-dated version of my paper written a year ago: Is Our Accounting System

Flawed? – It may be insensitive to capital destruction. Up-dating was prompted by events

during that fateful year. In several passages I had to change the subjunctive mood to the

indicative: the hypothetical depression has, unfortunately but not unpredictably, become an

actual depression.

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shows that the assets and liabilities of a firm do balance out at all times, provided that we

introduce a new item in the liability column that has been variously called by subsequent

authors “net worth”, “goodwill”, and “capital”. This innovation makes it easy to check the

ledger for accuracy by finding that, at the close of every business day, assets minus liabilities

is equal to zero. If not, there must be a mistake int he calculation.

But what Pacioli discovered was something far more significant than a method of

finding errors in the arithmetic. It was the invention of what we today call double-entry bookkeeping,

and what Göthe has called “the finest product of the human brain” (Wilhelm

Meister’s Apprenticeship.)

Why was this discovery so important in the history of Western Civilization? Because,

for the first time ever, it was possible to calculate and monitor shareholder equity with

precision. This is indispensable in starting and running a joint-stock company. Without it new

shareholders could not get aboard, and old ones could not disembark safely. There would be

no stock markets. The national economy would be a conglomeration of cottage industries,

unable to undertake any large-scale project such as the construction of a transcontinental

railroad, or the launching of an intercontinental shipping line.

The invention of the balance sheet did to the art of management what the invention of

the compass did to the art of navigation. Seafarers no longer had to rely on clear skies in order

to keep the right direction. The compass made it possible to sail under cloudy skies with equal

confidence. Likewise, managers no longer have to depend on risk-free opportunities to keep

their enterprise profitable. The balance sheet tells them which risks they may take and which

ones they must avoid. It is no exaggeration to say that the present industrial might of Western

Civilization rests upon the corner-stone of double-entry book-keeping. Oriental (Chinese) and

Middle-Eastern (Arab) civilizations would have outstripped ours if they had chanced upon the

discovery of the balance sheet first. By the same token, the continuing leadership of the West

depends on keeping accounting standards high and isolated from political influences.

Barbarous relic or accounting tool?

There is cause for concern in this regard. For the past 75 years the West has been fed the

propaganda line, attributed to John Maynard Keynes, that the gold standard is a “barbarous

relic”, ripe to be discarded. The unpleasant truth, one that propagandists have ‘forgotten’ to

consider, is that the gold standard is merely a proxy for sound accounting and, yes, for sound

moral principles. It is an early warning system to indicate erosion of capital. It was not the

gold standard per se that politicians and adventurers wanted to overthrow. They wanted to get

rid of certain accounting and moral principles, especially as they apply to government and

banking, that had become an intolerable fetter upon their ambition for aggrandizement and

perpetuation of power. Historically, accounting and moral principles had been singled out for

discard before the gold standard was given the coup de grâce.

The attack on accounting standards and on the gold standard was heralded by the

establishment in 1913 of the Federal Reserve System (the Fed) in the United States, the chief

engine of monetizing government debt followed, a decade later, by the illegal introduction of

the Fed’s ‘open market operations’. The latter has made bond speculation risk free, ultimately

driving down interest rates to near zero, resulting in the destruction of capital. Just how the

monetization of government bonds has led to a hitherto unprecedented, even unthinkable,

corruption of accounting standards ― this is a question that has never been addressed by

impartial scholarship before.

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Bonds and the Wealth of Nations

In order to see the connection we must recall that any durable change of interest rates has a

direct and immediate effect on the value of financial assets. Rising interest rates make the

value of bonds fall, and falling rates make it rise. As a result of this inverse relationship the

Wealth of Nations would flow and ebb together with the variation of the rate of interest.

Benefits and penalties would be distributed capriciously and indiscriminately, without regard

to merit. It follows that the world economy needs a ‘flywheel regulator’ to keep interest rates

stable or, more precisely, to let the increase in the Wealth of Nations impart a rather gentle

falling trend to interest rates.

That flywheel regulator was the gold standard before it was forcibly removed and

discarded by irresponsible politicians trampling on the Constitution. Under the gold standard

the rate of interest was stable and violent contractions in the Wealth of Nations were

unknown. A lasting increase in the rate of interest could only occur in the wake of a natural

disaster such as an earthquake, flood, or crop failure. Remarkably, these were cushioned by

the spreading of the impact from the stricken country to the community of gold standard

nations. War destruction would also cause the rate of interest to rise. In all these cases a

higher rate of interest was beneficial. It had the effect of spreading the loss of wealth due to

destruction of property more widely, easing the burden on individuals. Those segments of

society, or those countries, that were lucky enough to escape physical destruction had to share

in the loss through paying the increased cost of servicing capital due to higher interest rates.

Everyone was prompted to work and save harder in order that the damage might be repaired

quickly and expeditiously. As the rate of interest gradually returned to its original level, the

Wealth of Nations expanded. Once again, everybody shared equally as the lower interest rate

benefited all through the reduction in the cost of servicing capital.

It is not widely recognized that the chief eminence of the gold standard is not to be

found in stabilizing the price structure (which is neither desirable nor possible). It is to be

found in stabilizing the interest-rate structure. By ruling out capricious and disturbing swings,

the Wealth of Nations is maximized.

The gold standard ruled supreme before World War I. It was put into jeopardy when

general mobilization was ordered in 1914 by the manner in which belligerent governments set

out to finance their war effort. These governments wanted to perpetuate the myth that the war

was popular and there was no opposition to the senseless bloodshed and destruction of

property that could have been avoided through better diplomacy. The option of financing the

war through taxes was ruled out as it might make the war unpopular. The war was to be

financed through credits. In more details, war bonds were issued in unprecedented amounts,

subsequently monetized by the banking system. Naturally, these bonds could not possibly be

sold without a substantial advance in the rate of interest. Accordingly, the Wealth of Nations

shrank even before a single shot was fired or a single bomb dropped.

Sinking fund protection

Under the gold standard bondholders were protected against a permanent rise in the rate of

interest (which in the absence of protection would decimate bond values) by the provision of a

sinking fund. In case of a fall in the value of the bond the sinking fund manager would enter

the bond market and would keep buying the bond until it was once more quoted at par value.

Every self-respecting firm issuing bonds would offer sinking-fund protection.

Even though governments did not offer it, it was understood and, in the case of

Scandinavian governments explicitly stated, that the entire bonded debt of the government

would be refinanced at the higher rate, should a permanent rise in the rate of interest occur.

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Bondholders who have put their faith in the government would not be allowed to suffer

losses. The banks, guardians of the people’s money, could regard government bonds as their

most trusted earning asset. They were solid like the rock of Gibraltar. Such faith, at least in

Scandinavian government obligations, was justified. The risk of a collapse in their value was

removed. Governments, at least those in Scandinavia, occupied the moral high ground. The

money they borrowed belonged, in part, to widows and orphans. They took to heart the

Scriptural admonition and did not want to bring upon themselves the curse pronounced on

tormentors of widows and orphans.

Law of Assets

However, there was a problem with war bonds issued by the belligerent governments. They

were quickly monetized by the banking system making the refinancing of bonded debt

impossible. This created a dilemma for the accounting profession. According to an old bookkeeping

rule going back to Luca Pacioli that we shall refer to here as the Law of Assets, an

asset must be carried in the balance sheet at acquisition value, or at market value, whichever

is lower. In a rising interest-rate environment the value of bonds and fixed-income obligations

are falling, and this fall must be faithfully recorded in the balance sheet of the bondholder.

There are excellent reasons for this Law. In the first place it is designed to prevent

credit abuse by the banks and other lending institutions. In the absence of this Law banks

could overstate the value of their assets that might be an invitation to credit abuses to the

detriment of shareholders and depositors. If the abuse went on for a considerable period of

time, then it could lead to the downfall of the bank. In an extreme case, when all banks

disregarded the Law of Assets, the banking system could be operating on the strength of

phantom capital, and the collapse of the national economy, to say nothing of the world

economy, might be the ultimate result. For non-banking firms the danger of overstating asset

values also exists, and can serve as an invitation to reckless financial adventures. Even if we

assumed that upright managers would always resist the temptation and stay away from

dubious adventures, in the absence of the Law of Assets the balance sheet would be an

unreliable compass to guide the firm through turbulence, materially increasing the chance of

making an error. Managerial errors could compound and the result could again be bankruptcy.

Economists of a statist persuasion would argue that an exception to the Law of Assets

could be safely made in case of government bonds. The government’s credit, like Caesar’s

wife, is above suspicion. The government will never go bankrupt. Its ability to retire debt at

maturity cannot be doubted. As a guarantee these economists point to the government’s power

to tax. However, the problem is not with paying the face value of the bond at maturity, but

with the purchasing power of the proceeds. By that standard, the U.S. government is guilty of

partial and concealed default on every single 30-year bond it has sold since the establishment

of the Fed in 1914. Currency depreciation is a more subtle and, hence, a more treacherous

form of default. Governments, however powerful, cannot create something out of nothing any

more than individuals can. They cannot give to Peter unless they have taken it from Paul first.

Nor is the taxing power of governments absolute. Financial annals abound in cases where

taxpayers have revolted against high or unreasonable taxes, sometimes overthrowing the

government in the process. If the taxing power of governments had been absolute, then they

could have financed World War I out of taxes. Bondholders would have suffered no loss of

purchasing power, at least not on the victors’ side.

It is true that governments as a rule do not go bankrupt, but this may be a

disadvantage. Putting a value on bonds higher than what they would fetch in the market is a

fool’s paradise. Governments could use methods, fair or foul, to stave off the ill effects of

their own profligacy. Awakening could be postponed, but it would be made that much ruder.

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A strict application of the Law of Assets would have made most banks and financial

institutions in the belligerent countries insolvent. The dilemma facing the accounting

profession was this.

Illiquid or insolvent?

The story how the accounting profession solved the dilemma has never been told. It may be a

safe assumption that the dilemma was solved for it by the belligerent governments in

prohibiting the public disclosure of the banks’ true financial condition. A new accounting

code was created, far more lenient in adjudicating insolvency. The Law of Assets was thrown

to the winds, replaced with a more relaxed one allowing the banks to carry government bonds

at face value, regardless of true market value, as if they were a cash item. A new term was

invented to describe the financial condition of a bank with a hole in the balance sheet

punctured by the falling value of government bonds. Such a bank was henceforth considered

“illiquid”, but still solvent. Never mind that the practice of allowing the illiquid bank to keep

its door open is a dangerous course to follow. It had far-reaching consequences, including a

threat to the very foundations of Western Civilization. It was a death sentence on the gold

standard with a stay of execution. It was throwing the gates open to wholesale currency

debasement world-wide. It is not an exaggeration to say that the present unprecedented

financial crisis is a delayed effect of the unwarranted relaxation of accounting standards back

in 1914.

While I cannot prove that a secret gag-rule was imposed on the accounting profession,

I am at a loss to find an explanation why an open debate on the wisdom of changing timehonored

accounting principles has never taken place. Apparently there were no defections

from the rank and file of accountants denouncing the new regimen as dangerous and

unethical. The underhanded changes in accounting practice have opened the primrose path to

self-destruction.

The dominant role of the West in the world was due to the moral high ground staked

out by the giants of the Renaissance, among them Luca Pacioli. As this high ground was

gradually given up, and the commanding post was moved to shifting quicksand, rock-solid

principles gave way to opportunistic guidelines. Western Civilization has been losing its claim

to leadership in the world. It comes as no surprise that this leadership is now facing its most

serious crisis ever.

The chickens came home to roost as early as 1921 when panic swept through the U.S.

government bond market. All banks found that their capital was seriously impaired as a result

of the panic. Financial annals fail to deal with this crisis (exception: B. M. Anderson’s

Financial and Economic History of the United States, 1914-1946, posthumously published in

1949, see reference at the end). Nor was it given the coverage it deserved in the financial

press. Information was confined to banking circles. An historic opportunity was missed to

mend the ways of the world gone astray in 1914. It was the last chance to avert the Great

Depression of 1930 already in the making, to say nothing of other great depressions to follow.

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Law of Liabilities

Purely by using a symmetry argument we may formulate another fundamental principle of

accounting: the Law of Liabilities. It asserts that a liability must be carried in the balance

sheet at its value at maturity, or at liquidation value, whichever is higher. Since liquidation

would have to take place at the current rate of interest, in a falling interest-rate environment

the liabilities of all firms are rising. The reason for this Law is to prevent the government,

banks, and other firms from understating their liabilities that would spell a great danger to the

national economy. This danger has been completely disregarded by the profession of the

economists, as it has by that of the accountants.

Economists have failed to raise their voice against the folly of allowing the interest rate

structure to fluctuate for reasons of political expediency, implicit in the application of

both Keynesian and Friedmanite nostrums. It is possible that the reason for this failure was

the fatal blind spot that economists appear to have in regard to the danger of overestimating

national income in a falling interest-rate environment.

The proposition that a firm ought to report liabilities at a value higher than the amount

due at maturity whenever the rate of interest falls is, of course, controversial. Let us review

the reasons for this crucial requirement. If the firm is to be liquidated, then all liabilities

become due at once. Sound accounting principles demand that sufficient capital be maintained

at all times to make liquidation without losses possible. If the rate of interest were to fall,

then, clearly, earlier liabilities had been incurred at a rate higher than necessary. For example,

if an investment had been financed through a bond issue or fixed-rate loan, then better terms

could have been secured by postponing it. A managerial error in timing the investment had

been made. This is a world of crime and punishment where even the slightest error brings

with it a penalty in its train. Marking the liability in the balance sheet to market is the penalty

for poor timing. If the investment had been financed out of internal resources, the penalty was

still justified. Alternative uses for the resource would have generated better financial results.

Even if we assume that the investment was absolutely essential at the time it was

made, and we absolve management of all responsibility in this regard, the case for an increase

in liability still stands. After all has been said and done, there is a loss that must not be swept

under the rug. If the balance sheet is to reflect the true financial position, then the loss ought

to be realized. Any other course of action would create a fool’s paradise. To see this clearly,

consider losses due to accidental fire destroying physical capital not covered by insurance.

The loss must be realized as it is necessary that the balance sheet reflect the changed financial

picture caused by the fire. That’s just what the balance sheet is for. The proper way to go

about it is a three-step adjustment as follows:

(1) Create an entry in the asset column called “capital fund to cover fire loss”.

(2) Create an equivalent entry in the liability column.

(3) Amortize the liability through a stream of payments out of future income.

It is clear that if the accountant failed to do this, then he would falsify all subsequent income

statements. As a result losses would be reported as profits and phantom profits would be paid

out as dividends. Not only would this weaken the financial condition of the firm, but it would

also render the balance sheet meaningless, which may compound the error further.

Exactly the same holds if the loss was due not to accidental fire but to a fall in the rate

of interest. The way to realize the loss is analogous. A new entry in the asset column must be

created under the heading “capital fund to cover shortfall due to capitalizing interest payments

at a lower rate”, against an equivalent entry in the liability column, to be amortized through a

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stream of payments out of future income. This is not an exercise in pedantry. It is the only

proper way to realize a loss that has been incurred as a result of the inescapable increase in the

cost of servicing productive capital already deployed, in the wake of a fall in the rate of

interest. Ignoring that loss would by no means erase it. It may well compound it.

The example of Japan

I anticipate a torrent of criticism asserting that there is no such a thing as the Law of

Liabilities in accounting theory or practice. I submit that I have no formal training in

accounting, or in the theory and history of accounting. Nor do I recall having seen the Law of

Liabilities in any of the textbooks on book-keeping that I have perused (although I have seen

the Law of Assets in older textbooks that have been discarded). But I shall argue that either

Law follows the spirit if not the letter of Luca Pacioli. Affirming one while denying the other

makes no sense. Every argument that supports one necessarily supports the other. The Law of

Liabilities is a mirror image of the Law of Assets, arising out of the perfect logical symmetry

between assets and liabilities.

Ignoring either Law is a serious breach of sound accounting principles, possibly with

grave consequences. Consider the example of Japan, allowing the rate of interest to fall

practically all the way to zero during a fifteen-year period. Present (in my opinion deeply

flawed) accounting rules allowed Japanese banks, including those that not so many years ago

were among the world’s ten largest, to understate the value of their liabilities. Hence they

could report their losses as profits. Wholesale capital consumption and destruction was the

result, without anybody realizing what was going on. Japan now has to live with a brain-dead

banking system operating on phantom capital. The national economy has been brought to its

knees spelling deflation, depression, or worse, as indeed it seems to be happening right now.

The cancer of depression has been metastasizing across the Pacific through the yen-carry

trade, foolishly encouraged by the Fed and the Bank of Japan as a way to push interest rates

even lower in the United States.

Rather than analyzing the Japanese example and drawing the appropriate conclusions,

policy-makers in the U.S. had an irresistible itch to follow Japan’s jump into the abyss of the

Black Hole of zero interest. The result, perfectly predictable, is catastrophic. Yet the lesson

has not been learned: after successfully massaging the short end of the yield curve to zero, on

March 18, 2009, the Fed announced that it has set out to massage the long end as well.

Historic failure to recognize the Law of Liabilities

Even if the fact were established that the Law of Liabilities has never been spelled out in any

accounting code going back all the way to Luca Pacioli, we should still not jump to the

conclusion that there is no justification for it. A convincing argument can be made explaining

why the Law of Liabilities has escaped the notice of upright and knowledgeable accountants

in the past with the consequence that it has never been codified. Historically, rising rather than

falling rates have been the rule in spite of the fact that, since time immemorial, the powers that-

be have shown a persistent bias favoring debtors at the expense of creditors, as

demonstrated by their desire to suppress the rate of interest by hook or crook. However, their

effort has been counter-productive. The usuriously high rates charged on loans in precapitalistic

times were not due to an alleged greed of the usurers. They were due to the usury

laws themselves. Charging and paying interest had been outlawed, but the result was not

lower interest on loans as the authors of the usury laws had foolishly anticipated. On the

contrary, the result was rates higher than what the free market would have charged. The

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excess represented compensation for risks involved in doing an extra-legal business

transaction.

Even though the usury laws were later repealed, other anti-business measures have

remained on the books that resulted in keeping interest rates higher than they would have been

in the absence of government interference. For these and other reasons, traditionally, the

problem was not falling but rising rates. In such an environment the Law of Liabilities

remained inoperative and was easily overlooked. It is hard to discover a law that has been

inoperative through all previous history.

Revisionist history of the Great Depression

The picture changed drastically when the Fed started its illegal open market operations. (The

practice was later legalized through ex post facto legislation.) Thereafter falling rates became

a regular feature of the landscape. Speculators were happy to jump on the bandwagon of risk free

profits. They could easily preempt the Fed by purchasing the bonds beforehand. After the

Fed has bought its quota, speculators could dump the bonds and pocket their profits. The net

result was a falling interest rate structure.

The undeniable fact is that the opportunity for risk-free profits from bond speculation

due to the introduction of open market operations was a major cause of the Great Depression.

Yet to this day textbooks on economics hail open market operations as a refined tool in the

hands of monetary authorities “to keep the economy on an even keel”. Only one other mistake

economists have made does match this in enormity. Textbooks blame the Great Depression on

the “contractionist bias” of the gold standard.

The truth is just the opposite. A second major cause of the Great Depression, in

addition to the Fed’s illegal open market operations, was the government’s sabotaging of the

gold standard in preparation for its overthrow, as I shall now explain. The persistent fall of

interest rates in the 1930’s has never been fully explained by the economists. They ignored

the fact that the only competitor for government bonds, gold, has been knocked out through

confiscation, or the threat thereof, as well as other measures of intimidation. When, finally,

Britain and the United States left the gold standard, government bonds were freed from their

only competitor. Their value started to rise, making interest rates fall, causing prices to follow

suit. The Great Depression was self-inflicted. Governments in their zeal fired the policeman

cordoning off the Black Hole of zero interest to prevent interest rates from falling in.

Speculators were quick to understand that this also meant the removal of the ceiling on bond

prices. For the first time ever, there was an opportunity to bid bond prices sky-high.

Speculators abandoned the high-risk commodity markets in droves and flocked to the bond

market to reap risk-free profits made available by the regime of open market operations. You

cannot understand the Great Depression without understanding how speculators reacted to the

forcible removal of gold, the only competitor for government bonds, from the scene.

Thus the Great Depression had a dual cause: (1) the illegal introduction of open

market purchases of government bonds by the Fed, and (2) the unconstitutional suspension of

the metallic monetary standard by the government. Both measures worked to destabilize

interest rates, more precisely, they both worked towards establishing a falling trend.

Paying out phantom profits

Superficial thinking may suggest that if the rise of interest rates is bad, then their fall is good

for the economy. Not so. A falling rate is even more damaging than a rising one. I am aware

that my thesis is highly counter-intuitive. I have been challenged by many other economists

who deny the validity of my contention. They argue that if the present value of future income

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is lower when discounted at a higher rate, then it must be higher when discounted at a lower

rate of interest. We may admit that this statement is true. However, obviously, the firm has to

be around to collect the higher income. Many of them won’t be as they succumb to capital

squeeze caused by the very falling of the rate that is supposed to be beneficial for them.

My critics hold that falling rates are always beneficial to business and it is

preposterous to suggest that they aggravate deflation. These critics confuse a falling structure

of interest rates with a low but stable structure. While the latter is beneficial, the former is

lethal. When interest rates are falling, the low rates of today will look like high rates

tomorrow. A prolonged fall creates a permanently high interest-rate environment. This

paradox explains the reluctance of the mind to admit that falling rates spell deflation and, in

an acute case, depression.

Falling rates mean that businesses have been financed at rates far too high. This fact

ought to be registered as a loss in the balance sheet, and be compensated for by an injection of

new capital. If businesses choose to ignore the loss, and they merrily go on paying out

phantom profits in the form of dividends and executive compensation, then they will further

weaken their capital structure. When they finally plunge into bankruptcy, they wonder what

has hit them. They don’t understand that they have failed to augment their capital in the face

of falling interest rates. Their downfall is due to insufficient capital. In a falling interest rate

environment all firms are affected by the elusive process of capital destruction. This was true

in the 1930’s; it is still true today. Incidentally, this also explains why American producers

have been going out of business in droves since the mid-1980’s, resulting in the export of the

best-paying industrial jobs to Asian countries such as China and India where labor costs were

lower.

The U.S. government is apparently unconcerned about the fact that the liquidation

value of its debt is escalating by several orders of magnitude due to falling interest rates. It

has increased a thousand-fold during the past 25 years, due to this one cause alone! After all,

the Fed has the printing presses to create dollars with which any liability can be liquidated,

however large.

Cause: falling interest rates – effect: falling prices

American producers are not so fortunate. They have to produce more and sell more if they

don’t want to sink deeper in debt. But selling more may not be possible in a falling interestrate

environment except, perhaps, at fire-sale prices. What this shows is that the cause of

deflation is not falling prices: it is falling interest rates. Falling prices is the effect. Let’s spell

it out how this mechanism works. As interest rates fall, a vicious spiral is set in motion: lower

rates sending prices lower, and lower prices sending rates lower still. Bond speculators take

advantage of the opportunity created by open market operations. They front-run the Fed in

buying government bonds first. The resulting fall in interest rates bankrupt productive

enterprise that could not extricate itself from the clutches of debt contracted earlier at higher

rates. The debt becomes ever more onerous as its liquidation value escalates past the ability to

carry it. The squeeze on capital causes wholesale bankruptcies among the producers.

While they clearly have the power to put unlimited amounts of irredeemable currency

into circulation, central banks have no power to make it flow in the “approved” direction.

Money, like water, refuses to flow uphill. In a deflation it will not flow to the commodity and

real estate markets to bid up prices there, as central bankers have hoped. Rather, it will flow

downhill, to the bond market, where the fun is, bidding up bond prices. As the central bank

has made bond speculation risk free, the bond market will act as a gigantic vacuum cleaner

sucking up dollars from every nook and cranny of the economy. The sense of scarcity of

money becomes pervasive.

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In feeding ever more irredeemable currency to the money market the central bank cuts

the figure of a cat chasing his own tail. Contrary to the universal delusion that goes by the

name “Quantity Theory of Money”, more fiat money pushes interest rates lower and falling

interest rates squeeze producers more. They cut prices in desperation and cry out for the

creation of still more fiat money. To be sure, they get what they ask for. But their medicine

turns out to be their poison. The creation of new money has a cost, namely, the Fed’s open

market purchases of government bonds and the concomitant bull speculation in the bond

market. Producers are squeezed further and are forced to make more price cuts. The vicious

spiral is on.

The interest rate structure and the price level are linked. Subject to leads and lags, they

keep moving together in the same direction. Falling interest rates sooner or later induce falling

prices. [this is called linkage. See Fekete: “… linkage, the phenomenon of commodity prices and interest rates moving together subject to leads and lags.”Kenyes coined the term Gibson’s Paradox for this fact.  At least for commodity prices, during the years of the classical gold standard.  Sometimes the price level leads and the rate of interest lags; at other times, the other way around. Also see Fekete: Jackson’s linkage. ]

This is the lesson from the revisionist theory of depressions, a lesson that has been

ignored by economists.

Putting bank ratios in the vise

As the current global banking and credit crisis shows, the destruction of the capital of the

producing sector goes hand-in-hand with the destruction of the capital of the financial sector.

Falling interest rates shrink bank capital across the board without the shrinkage being

detected. All banks are weakened simultaneously. They should have augmented their capital

or should have reduced their assets in the face of falling interest rates. They had done neither.

In a mad pursuit of high leverage they embarked upon a policy of increasing assets in the face

of capital erosion. Bank ratios have been put in the vise: they are squeezed on the right and on

the left. They are squeezed on the liability side because the liquidation value of liabilities

stands to be revised upwards; but they are also squeezed on the asset side because the value of

assets stands to be revised downwards.

At first, the banks thought they were making fabulous profits. It was only later that it

downed [dawned?] upon them that, in fact, what they were paying out in the form of dividends and

compensation were phantom profits. This compounded the problem of capital erosion. By

2008 the banks have reached the stage, more or less simultaneously, where all of their capital

was wiped out. The credit crisis burst upon the scene with elemental force.

Through its open market operations the Fed has, unwittingly, generated a deflationary

spiral that ultimately bankrupted not just the producing sector, but the financial sector as well.

Like the Sorcerer’s Apprentice, the Fed started the march to the Black Hole of zero interest,

but did not have a clue how to stop it when the pull of the Black Hole has become irresistible.

At that point the deflationary spiral got out of control.

The onset of Great Depression II

It is nothing short of frightening to see how policy-makers in the U.S. have misread and

misinterpreted the danger signals warning of an imminent collapse of the financial system and

the economy, and how they continue to prescribe the wrong medicine. We must face the fact

that the present crisis is far worse than that of 1929. For one thing, the economy is so much

larger making the collapse more damaging. Even more serious is the increasing debt burden

that the collapsing economy is no longer able to carry.

The credit of the United States was incomparably stronger in 1929. Eighty years ago

this country was the largest creditor in the world, a position it was to keep for the next forty

years. By now the U.S. is the largest debtor nation in the world that needs to borrow money to

pay interest on its debt. The tipping point was the year 1971 when the dollar was formally

made an irredeemable currency. During the last forty years a colossal dissipation of wealth,

11

unprecedented in history, has taken place. It was mostly unseen since it was papered over by

an artificially fed boom in consumption. It is altogether futile to expect that the American

consumer will pull up the world economy with his renewed spending if given the necessary

pump-priming followed by sufficient stimulus.

Today the greatest creditor nation in the world is China. Is it realistic to expect that the

Chinese consumer will take over the role traditionally played by the American consumer,

given the fact that his government is a prisoner of Communist ideology?

We are still far from the trough of this depression, officially labeled a ‘recession’. At

the trough the devastation will be far greater than that experienced in 1932, if for no other

reason that there was no derivatives tower then, whereas we have one now that threatens the

world with toppling. Only the tip of the derivatives iceberg has been identified by the captain

of this ‘unsinkable’ Titanic, not the invisible submerged part. He is oblivious of the fact that

the inevitable collision will take place at greater depths.

Worst of all is the blockheadedness of the policy-makers as they desperately stick to

their long-since discredited Keynesian nostrums. Every measure they propose is counterproductive.

They seem to be unaware of the truism that pump-priming is useless if there is no

water in the well. Likewise, there is no point in stimulating an organism that suffers from

blood poisoning. One has to treat the disease first. To be sure, the world suffers from blood

poisoning caused by irredeemable currency. This is the problem that has to be addressed first.

How to stop Great Depression II?

We have to stop the march to the Black Hole of zero interest. Restoring sound accounting

standards is imperative. It is most unfortunate that the first tentative step in this direction, the

compulsory marking of bank assets to market, will probably be rescinded as the authorities

cave in to the vicious agitation of the bankers. Observers still have their blinkers on and

cannot see the capital destruction caused by the failure to carry liabilities in the balance sheet

at liquidation value. We must stop turning a blind eye to the deleterious effect of a falling

interest rate environment on capital deployed in support of production.

[I.e., industrial capital, plant and equipment which allows labor to add value.] Open market

operations of the Fed must be outlawed and risk-free speculation in bonds stopped. They have

been the chief cause of deflation as demonstrated by the pull of the Black Hole of zero

interest.

The gold standard must be rehabilitated in order to abolish the inadmissible monopoly

of government bonds. Some say this is unlikely to happen because it would be too painful.

However painful, the alternative is many times more painful. The alternative spells a total

breakdown of law and order due to unacceptable levels of unemployment, much worse than

that experienced in the 1930’s. The unraveling of social fabric threatens the survival of our

civilization.

The key is in the hand of the U.S. government. It is the same key that was used to lock

the U.S. Mint to silver in 1873, and to gold sixty years later, in 1933. By using it now to open

the U.S. Mint to both silver and gold, the U.S. government can effectively cordon off the

Black Hole of zero interest to prevent further damage.

At stake is nothing less than the question whether America can reclaim control over its

destiny, saving Western Civilization in the process.

April 6, 2009 l[ A very similar version dated June 29, 2009 exists.]

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References

By the same author:

Kondratieff Revisited, May, 2001

Deflation or Runaway Inflation? July, 2001

The Economic Consequences of Mr. Greenspan, December, 2001

Japan’s Finest Hour, January, 2002

Revisionist View of the Great Depression I-II, March, 2002

The Black Hole of Zero Interest Revisited, August, 2002

Wrecker’s Ball of Swinging Interest Rates, September, 2002

Central Banker As the Quartermaster-General of Deflation, January, 2003

Bubble That Broke the World, June, 2003

Stop Greenspan from Plunging America into a Depression! June, 2003

Tainted Research, June, 2003

Gold Demonetization Hoax, August, 2003

Gold Is the Cure for the Job-Drain, September, 2003

The Shadow Pyramid, November, 2007

Fiat Currency: Destroyer of Capital, December, 2007

Fiat Currency: Destroyer of Labor, December, 2007

Opening the Mint to Gold and Silver, February, 2008

Is Our Accounting System Flawed? – It may be insensitive to capital destruction,

May 20, 2008

These and other papers of the author can be accessed at: www.professorfekete.com

Benjamin M. Anderson, Economics and the Public Welfare, A financial and economic history

of the United States, 1914-1946, (first published in 1949); Indianapolis, 1979: Liberty Press,

p 80 ff.

13

Calendar of Events

Instituto Juan de Mariana: Madrid, Spain, June 12-14, 2009

Seminar with Prof. Fekete on Money, Credit, and the Revisionist Theory of

Depressions

For information, contact: gcalzada@juandemariana.org

OroY Finanzas & Portal Oro: Madrid, Spain, June 18, 2009

Gold and Silver Meeting Madrid 2009

For information, contact: preukschat_alex@hotmail.com or

gcalzada@juandemariana.org or

http://www.portaloro.com/aemp.aspx or

info@portaloro.com

San Francisco School of Economics: A Series of three Investment Seminars:

July 25; August 1; and August 8, 2009

The Gold and Silver Basis; Backwardation; Trading Gold in the Present Environment;

Wealth Management under the Regime of Irredeemable Currency. Given by Professor

Fekete and Mr. Sandeep Jaitly of Soditic Ltd., London, U.K. Enrolment is limited,

first come first served. For more information, see: www.sfschoolofeconomics.com

San Francisco School of Economics: July 27-August 7, 2009

Money and Banking, a 20-lecture course given by Professor Fekete. Enrolment is

limited; first come, first served. The Syllabus for this course can be seen on the

website: www.professorfekete.com, see also: www.sfschoolofeconomics.com

University House, Australian National University, Canberra: first week of November, 2009

Peace and Progress through Prosperity: Gold Standard in the 21st Century

This is the first conference organized by the newly formed Gold Standard Institute.

For further information, e-mail: feketeaustralia@gmail.com ,

On the Gold Standard Institute, e-mail philipbarton@goldstandardinstitute.com

Professor Fekete on DVD: Professionally produced DVD recording of the address before the

Economic Club of San Francisco on November 4, 2008, entitled The Revisionist

History of the Great Depression: Can It Happen Again? plus an interview with

Professor Fekete. It is available from www.Amazon.com and from the Club

www.economicclubsf.com at the price of $14.95 each.