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September 21, 2008

Why America's Economic Crisis was Unavoidable
by Gerard Jackson

As the financial crisis unfolds Americans have nothing to fear other than Congress. Ignorant politicians helped create this monetary mess and ignorant politicians will make it worse if they are not stopped. John McCain believes that the fault lies with Wall Street's 'unbridled corruption and greed". Treasury Secretary Hank Paulson took a similar line when he announced: "Raw capitalism is dead". For my money the most amusing condemnation came from the ever-so righteous Thomas Frank1 who pompously wrote:

No, this is the conservatives' beloved financial system doing what comes naturally. Freed from the intrusive meddling of government, just as generations of supply-siders and entrepreneurial exuberants demanded it be, the American financial establishment has proceeded to cheat and deceive and beggar itself -- and us -- to the edge of Armageddon. It is as though Wall Street was run by a troupe of historical re-enactors determined to stage all the classic panics of the 19th century. (Get Your Class War On, Wall Street Journal, 17September 2008)

Apart from once again revealing an utter ignorance of economics, economic history and the history of economic thought -- an ignorance that he shares with Republicans -- he also exposed -- in between whining about nasty Republicans beating up angelic Democrats -- his unreasoning hatred of capitalism and a deep seated loathing for defenders of the free market. The last point is important because critics on both sides of the political divide fail dismally to see that the crisis was actually created by a refusal to allow the free market do its work.

Fanny Mae and Freddy Mac were political creations that were run on the basis of political considerations. Yet the brilliant Mr Paulson seriously claims that their collapse is a condemnation of capitalism.

Nevertheless, Republicans have inadvertently found themselves in the favourable position of being able to take the moral high ground. After all, it was the Democrats led by Pelosi, Reid, Barney Frank and Dodd who confounded President Bush's attempt to reform these entities way back in 2005. And it was Democratic hacks that ran Fanny Mae and Freddy Mac in the interest of the Democratic Party, funnelling millions of dollars into the party's coffers while siphoning off scores of millions for themselves. It's also true that the drive by Democrats to force these 'companies' into making loans to people who were not credit worthy damaged their viability. This in itself was a recipe for financial grief.

If incompetence, political corruption and the unadulterated greed of the likes of Franklin Raines, the Clinton-appointed former head of Fannie Mae from 1998 to 2004, were all there is to it, then America would not be facing a financial crisis.

It ought to be clear that the Fanny Mae and Freddy Mac crisis is part of a larger and far more serious economic crisis, one that few economic commentators foresaw. There is nothing new here; financial crises are as old as banking itself. And every single one of these crises that ripped through economies shared the same characteristic irrespective of time or place. They were all preceded by a credit expansion. That is to say, credit unbacked by real savings. In plain English, monetary expansion.

One now hears constant chatter about billions of dollars being lost or spent on rescues. In fact, we have moved from billions to trillions. But one vital question is rarely or ever asked: Where did all this money come from? Answer: the Fed. Since1980 this bastion of monetary stability has expanded the money supply2 by some 700 per cent. And it is this wild monetary policy that fuelled the speculative frenzies of the '80s, '90s and the Bush administration.

Every speculative frenzy that I know off was triggered by a monetary expansion. Although these frenzies obviously require huge amounts of credit to sustain them the economic commentariat still treat them as if they are a form of mania the roots of which are purely psychological. It was not always so. When writing of the "mob mind" that was still running rampant in stock market in 1928-1929 Benjamin M. Anderson summarised a speech made after the crash to New York State Chamber of Commerce

... which discussed, among other things, the phenomenon of the mob mind which had been so manifest in the year and a half that had preceded the crash. The speaker made the generalisation, familiar to social psychologists, that the more intense the craze, the higher the type of intellect that succumbs to it. (Benjamin M. Anderson, Economics and the Public Welfare: A Financial and Economic History of the United States 1914-1946, LibertyPress, 1979, p. 203).

The key to starting speculative booms is the rate of interest. By forcing the rate down below the market rate (the rate at which the demand for and supply of capital are equalised) the central bank creates excess credit that expands the demand for assets. If the rate is kept low enough there eventuates a situation where

it becomes impossible to make even the roughest kind of estimate of the probable rise in prices. Insecure sentiment governs the market; as prices continue to soar and profits are easily earned, the movement may rapidly reach fever-point. There is almost no limit to the rise in prices in spite of the fact that credit becomes more and more expensive. But when prices ultimately come to rest, and the prospect of further profits disappears, the credit position is so strained and the rate of interest is so high as immediately to bring about a contrary movement, which proceeding in analogous fashion may rapidly drag down prices even below their normal level3. (Knut Wicksell, Interest & Prices, Sentry Press, New York, N. Y., 1936, p. 98).

There is virtual agreement among economists (the Austrians are the usually the exception) that the money supply should expand at the same rate as output if a deflation is to be avoided. Firstly, it is plain to see that whatever measure of money supply is used, it would be absurd to deny that it has not risen at a far greater rate than output. Then there is the fact that deflation is not defined by falling prices but a contractionary money supply. As the nineteenth century amply demonstrated, falling prices, economic growth and an expanding job market are perfectly compatible. Even Milton Friedman admitted this when he observed that after the Civil War

[T]he price level fell to half its initial level in the course of less than fifteen years and, at the same time, economic growth proceeded at a rapid rate. The one phenomenon was the seedbed of controversy about monetary arrangements that was destined to plague the following decades; the other was a vigorous stage in the continued economic expansion that was destined to raise the United states to the first rank among the nations of the world. And their coincidence casts serious doubts on the validity of the now widely held view that secular price deflation and rapid economic growth are incompatible. (Milton Friedman and Anna J. Schwartz, A Monetary History of the United States 1867-1960, Princeton, N.J.: Princeton University Press, 1971).

Irrespective of what the likes of Frank and Paulson assert the problem is not the market but disequilibrium caused by ill-advised monetary policies that distort the both the capital and price structures. These policies create a myriad of opportunities to exploit unsustainable 'investment' opportunities that will vanish as soon as the central bank applies the monetary brakes, even if it does so slowly. For instance, the recessions of 1980-1982, 1990, 2000, and the 1994 slowdown were all preceded by a reduction in the rate of growth of the money supply.

However, no matter what evidence one presents in defence of the market, the fanatical likes of Thomas Frank will always blame the market and Republicans.

Note: Fears off a 1930s type of depression are totally unfounded. I shall explain why next week.

1. So-called American patriots like Frank, Pelosi, Reid, Biden, Dodd, etce., remind me of Roosevelt, another Democrat who always put his party before his country. Before Roosevelt's inauguration Hoover pleaded with him to cooperate in dealing with the banking crisis in an effort to avert further economic suffering. Roosevelt refused. To ensure that the facts would be correctly reported by history Hoover recorded the incident in his memoirs:

A statement of Rexford G. Tugwell (one of Roosevelt's close advisers) is worth repeating. James Rand, a responsible industrialist, ten days before the inauguration, had telephoned me this statement of Tugwell's as a warning. I confirmed his telephone message in the following letter, as I wanted it in the record:

My dear Mr. Rand:

I beg to acknowledge your telephone message received through Mr Joslin as follows:

"Professor Tugwell, adviser to Franklin D. Roosevelt, had lunch with me. He said they were fully aware of the bank situation and that it would undoubtedly collapse in a few days, which place the responsibility of the collapse in the lap President Hoover...."

When I consider this statement of Professor Tugwell's in connection with the recommendations we have made to the incoming administration, I can say emphatically that ... [they] would project millions of people into hideous losses for a Roman holiday.

Yours faithfully,

HERBERT HOOVER

Some years afterwards, I asked Ray Moley why Roosevelt refused to cooperate with me in the banking crisis. He wrote to me:

I feel when you asked him on February 18th to cooperate in the banking situation that he either did not realize how serious the situation was or that he preferred to have conditions deteriorate and gain for himself the entire credit for the rescue operation. In any event, his actions during the period from February 18th to March 3d would conform to any such motive on his part. (Herbert Hoover, The Memoirs of Herbert Hoover: The Great Depression 1929-1941, The MacMillan Company: New York, 1952, pp. 214-15).

2. The Austrian definition of money: currency component, all checkable deposits, savings deposits, U. government demand deposits and note balances, demand deposits due to foreign commercial banks, and demand deposits due to foreign official institutions. (Some Austrians exclude excluded deposits because they are credit transactions (savings deposits because they are immediately lent out and are therefore not available on demand.)

The Austrian definition of money is in keeping with Walter Boyd's classic definition:

By the words 'Means of Circulation', 'Circulating Medium', and 'Currency', which are used almost as synonymous terms in this letter, I understand always ready money, whether consisting of Bank Notes or specie, in contradistinction to Bills of Exchange, Navy Bills, Exchequer Bills, or any other negotiable paper, which form no part of the circulating medium, as I have always understood that term. The latter is the Circulator; the former are merely objects of circulation. (Walter Boyd, A Letter to the Right Honourable William Pitt on the Influence of the Stoppage of Issues in Specie at the Bank of England, on the Prices of Provisions, and other Commodities, 2nd edition, T. Gillet, London, 1801, p. 2).

3. Wicksell points out that even if rates are not lifted the speculative frenzy will burn itself out.

Gerard Jackson
BrookesNews.Com

Gerard Jackson is Brookes economics editor.

Copyright © 2005-2009 Gerard Jackson

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