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September 28, 2008

The Historical Thinking Behind America's Credit Crunch
by Gerard Jackson

It's is a rule of the universe that every effect has a cause. And so it is with the current financial crisis. Instead of starting with those economic theories -- that should be rightly called fallacies -- we need to take heed of the unfortunate fact that the vast majority of people are getting their information from the media. I say unfortunate because not only are the great majority of journalists incapable of explaining the processes that brought about the crisis, they are also outrageous political bigots who see it as their duty to blame every conservative politician in sight, even if it means lying.

One such journalist is Anatole Kaletsky. He is the associate editor of the London Times and is considered an expert in the field of economics, thereby providing more evidence of how bad the economic commentariat are. Applying the relentless power of his intellect to the crisis he arrived at the preconceived conclusion that the problem was the result of a "Bush-era combination of arrogance and incompetence". (Hank just didn't have a clue, The Times, 25 September 2008). But all is not lost because "the Democratic leadership in Congress " will save America and the world from the arrogant and incompetent Paulson and Bush. In an effort to support his contention, Kaletsky declared that

[Paulson's] inability to think seriously about solutions to the present financial crisis probably has deep ideological roots. . . Mr Paulson simply cannot believe that markets can be fundamentally wrong. He therefore cannot imagine, for example, that government [meaning Democratic politicians] judgments about the value of bank securities may, in some circumstances, reflect economic realities more accurately than market prices. (Ibid.)

One would not know from this statement that Kaletsky is a firm supporter of the Keynesian policy that generated the present monetary disorder. As I have explained many times before, these financial crises are always preceded by credit expansion. Since1980 the US money supply has expanded by about 700 per cent*. Now one should always bear in mind that bank credit always exceeds the amount of currency by a large multiple. For example, last July the Reserve Bank of Australia monetary aggregates show bank deposits were 82 per cent of M1.

Whenever an economy appears to be sliding into recession the central bank applies the Keynesian policy of fuelling credit expansion to combat what it mistakenly calls a fall in demand. (This is the kind of thinking that appalled classical economists). And this is precisely what the Fed did: it forced the rate down in June 2003 to 1 per cent. The following June it raised the rate to 1.25 per cent, far below what the market rate would have been. From then on it raised the rate by increments of 0.25 per cent until it reached 5.25 per cent in August 2007, after which the Fed reversed direction and starting lowering the rate again. It now stands at 1.9 per cent.

We can see that there was a considerable monetary loosening followed by a gradual tightening followed by further loosening. What is not obvious is that this roller-coaster monetary policy is the root of the problem. When an economy is flooded with credit the credit has to go somewhere. And that somewhere is just about every asset in sight. Even if lending institutions had not been successfully bullied by the Democrats into making unsustainable loans, loans would still have been made.

No matter how credit worthy many of the borrowers had been at the time of contracting the loan, a monetary tightening would still have created a financial crisis. Barely any of this ever penetrates the economic commentariat, particularly if they are as intellectually conceited as Mr Kaletsky. In 2005 Italy went into recession. Kaletsky opined that

The best response to underconsumption and mass unemployment, not only in Italy but throughout Europe, would [be] . . . a bold reduction in interest rates -- at least to the "emergency" level of 1 per cent [italics added] that revived the US economy in 2003, and preferably to zero, as in Switzerland and Japan. (Bold rate cut could avert euro exodus, The Times, June 13, 2005)

Yet arrogantly accuses Paulson and President Bush for being responsible for a financial crisis the cause of which he preaches as sound economics. Self-righteous chutzpah goes nowhere near describing this man's hubris and double-standards. This is the same character who stated that

the United States and Britain should do its utmost to maintain the strength of housing and consumer spending. Saddam Hussein and Osama bin Laden must not be allowed to win their war against civilisation by plunging the world into a catastrophic recession. Maintaining the strength of demand in the British economy is the biggest contribution that Gordon Brown could possibly make to the war effort in Iraq.' (Times Economic View, 8 April 2003)

Let us ignore for the moment his hypocrisy about the Iraq War and Saddam Hussein and focus on his economic analysis. "Maintaining the strength of demand" is Keynesian code for monetary expansion. When he wrote that M4* (broad money) was between 6 per cent and 8 per cent. By 2007 it exceeded 12 per cent, and is now in the 10 per cent range. And what was the end result? Last month the chancellor Alistair Darling warned that the UK could be facing the worst economic downturn in 60 years that will be "more profound and long-lasting" than most people realize. And Kaletsky has the nerve to pile on Paulson and President Bush.

Kaletsky based his economic advice on two very old and dangerous fallacies. The first one is demand deficiency and the second one is the belief that the destruction of capital promotes economic growth. For those who find the latter point incredible, it was Kaletsky who argued that severe restrictions on Co2 emissions would stimulate growth and raise the demand for labour because they would "have the effect on the world economy comparable to a large-scale war". (Digging beneath the gloom, The Australian 29 November 2000).

He is not alone in thinking that mass destruction of capital -- even when caused by carpet bombing -- is a terrific economic boon for any community. He is not alone in his economic idiocy. After the terrorist attack on the World Trade Centre Professor Paul Krugman wrote:

Ghastly as it may seem to say this, the terror attack -- like the original day of infamy, which brought an end to the Great Depression -- could do some economic good. (After the Horror, 14 September 2001)

This leads to the morbid conclusion that the terrorists would have done the US a huge favour if they had succeeded in destroying more buildings because that would have required more spending on reconstruction. It would also have raised the demand for the services of undertakers, though I'm not sure if they would have considered that a blessing in the circumstances.

The fallacy of demand deficiency and what one might call the 'blessings of destruction' had been thoroughly discredited by classical economists, the founders of a profession that now tends to treat them with a certain embarrassment, occasionally arguing that any economic writing that is "more than 20 years old has little value". No wonder old fallacies have been successfully resurrected. So how did the founders treat the idea of demand deficiency. As Say observed:

Returning to the painful situation in which every kind of industry in Europe is at present [post-Napoleon], I might add to the discouragement which results from the costs of production multiplied to excess, the disorders which these costs occasion in the production, distribution, and consumption of value produced; disorders which frequently bring into the market quantities greater than the want, keeping back those that would sell, and whose owners would employ their price in the purchase of the former.... (Jean Baptise Say, Letter to Mr. Malthus, Sherwood, Neely, and Jones, Paternoster-Row, 1821, pp. 57-58).

In the above passage Say fingered the problem: how is it that the costs of production were bid up to a point where they exceeded the value of their product? The answer is provided by the following passage in which he makes it clear that there was a massive entrepreneurial failure to properly calculate costs and estimate demand.

This superabundance, as I have already remarked, depends also upon the ignorance of producers or merchants, of the nature and extent of the want in the places to which they sent their commodities. In later years there have been a number of hazardous speculations, on account of the many fresh connexions with different nations. There was every where a general failure of that calculation which was requisite to a good result. . . . (Ibid. p.59).

Malthus had moved over to the under consumptionist camp. (Keynesians herald Malthus as a forerunner of Keynes, clearly showing that they have never read Malthus. In fact, Malthus's theory was that a free market would result in a permanent depression which increased investment would aggravate). In the following passage Say makes clear that once the miscalculations had been weeded out the depression would end. He was right. Malthus abandoned his underconsumption-stagnation thesis once the facts had established themselves in Say's favour.

... because many things have been ill done does it follow that it is impossible, with better instruction, to do better? I dare predict, that as the new connexions grow old, and as reciprocal wants are better appreciated, the excess of commodities will every where cease; and that a mutual and profitable intercourse will be established. (Ibid. p.59).

This is not say there were no dissenting voices. The now forgotten George Poulett Scrope was one such voice. Unfortunately for Scrope he never grasped the logic behind Say's law which led him to argue that

money likewise must be frequently varying in value. Bearing in mind this instability of value inherent in money of all kinds, we cannot fail to perceive that a general glut that is, a general fall in the prices of the mass of commodities below their producing cost is tantamount to a rise in the general exchangeable value of money; and is a proof, not of an excessive supply of goods, but of a deficient supply of money, against which the goods have to be exchanged. (George Poulett Scrope, Principles of Political Economy, Longman, Rees, Orme, Brown, Green, & Longman, Paternoster-Row, p.215)

He completely missed the vital point -- a point that Malthus also missed -- that loose money had generated a boom leading to factors of production having their prices bid up above their market clearing rates. When the boom was brought to an end a deflation followed and entrepreneurial miscalculations were revealed in the form of idle capital and unemployed labour.

(It was the currency school that had the idea that the boom-bust-cycle was the result of credit expansion. Elaborating on this fascinating subject would open another important chapter in the history of economic thought).

Kaletsky's suggestion that the judgment of politicians -- meaning the likes of Chuck Schumer, Harry Reid, Nancy Pelosi, Obama, etc., -- can "reflect economic realities more accurately than market prices" is the product of a statist mind that really doesn't know anything about market processes.

This is why he could make the absurd statement that "market failure is fundamental to any understanding of banking crises". Unfortunately this economic illiteracy is par for the course among the media's economic commentariat. The irony is that the kind of monetary policy that Kaletsky ardently supports is the one that creates the monetary disorders for which he blames market failure and Republican administrations.

With respect to the current crisis one should note that he refused to report the fact that President Bush had called on Democrats a number of times during his administration to reform Fanny Mae and Freddy Mac. The response of the Democrats was to frustrate every attempt at reform. And it was Bill Clinton himself who admitted that the Democrats were guilty of "resisting any efforts by Republicans in the Congress or by me when I was President to put some standards and tighten up a little on Fannie Mae and Freddie Mac". (ABC News, 25 September 2008)

Needless to say, Kaletsky did not confine himself to ignorant economic commentary, he had to declare that Bush has not "tangible achievement". Bush destroys a sadistic tyrant's regime and liberates scores of millions from fear and torment; he destroyed the Taliban and drove it into the mountains. Under his watch there has not been another successful attack on the US mainland. And all this was done in the face of a ferocious and thoroughly dishonest assault from the Democratic Party and a world-wide putrescent media.

At the end of the day, we find that Kaletsky is just another odious example of the ideological corruption that permeates the media and makes it subversive of democracy

*The Austrian definition of the money supply consists of the following: currency component of M1, total checkable deposits, US government demand deposits and note balances, demand deposits due to foreign commercial Banks, and demand deposits due to foreign official institutions, and savings deposits. There is some dispute about whether savings deposits should be included. If savings accounts are not transformed into checking accounts then including them in the money supply would be double counting, even if the bank lends the savings out to clients.

I used M4 because I have yet to examine UK monetary aggregates. Nevertheless, it is evident that there has been a significant increase in the money supply

Gerard Jackson
BrookesNews.Com

Gerard Jackson is Brookes economics editor.

Copyright © 2005-2009 Gerard Jackson

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