Learning from History?

In Keynes’ essay on The Consequences of Banks on the Collapse of Money Values, he clearly explains the distributive issues that arise when inflation rises unexpectedly. My macroeconomics professor, Dr. Ardnt, would be pleased to read this example of the unintended creation of winners and losers when inflation rates rose unexpectedly in the 1930s. Keynes begins his discussion by articulating that “a change in the value of money can gravely upset the relative positions of those who possess claims to money and those who owe money” and leads to a “re-arrangement of private fortunes and the ownership of wealth.” In the specific case of the economic slump of the early 1930s, deflation was so prevalent that the value of money was falling at unprecedented rates. This change made the amount that capital investors owed relatively larger, rendering them worse off and lenders in a superficially better position. The banks, the mediators in this exchange, were put in an uncomfortable position because their guarantee against the borrowers defaulting on their loans is the value of the capital they purchased; however, if the current money of the capital falls with deflation, the banker’s leverage on the loan weakens.

I found Keynes description of the precarious situation of Banks in the 1930s so striking because how closely it mirrors the situation leading to our recent Great Recession. Keynes, however, criticizes bankers for failing to see where this current trend is heading. Consider his fairly straightforward depiction of the precarious state of bankers under such extreme deflationary conditions: “They have given their guarantee to the real lender; and this guarantee is only good if the money value of the asset belonging to the real borrower is worth the money which has been advanced on it…It is for this reason that a decline in money values so severe as that which we are now experiencing threatens the solidity of the whole financial structure.” Given this rather clear description of extreme risk to do a fall in crisis, it becomes unclear why these bankers both then, decades ago, and very recently failed to act to change this trajectory. Leading up to the recent financial crisis, a strikingly similar trend developed; in this modern day financial crises, mortgages were being sold off into packages or derivatives, and similarly banks were engaging in lending contracts that were not secured by proper capital. This bank failure to accurately assess risk by packaging different loans into derivatives, earned them an extreme reputation for the surprisingly insightful commentary: “Derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal”(Warren Buffet 2002). This imbalance in monetary value of assets and money borrowed became so extreme that when people at last realized the absurdity of the risk banks were taking, our financial system came catapulting downward. The flaws that Keynes saw so clearly in bank behavior in the 1930s came to repeat itself nearly a century later. Blindness, apparently, is a reoccurring ailment.