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January 27, 2008

US Booms and Busts and a Little Monetary History
by Gerard Jackson

The extent to which media commentators are ignorant of economic history, let alone basic economics, is genuinely staggering. We got a good look at this ignorance when the 1990s boom was compared to the 1960s boom. Then many of the same commentators started to compare the stock market boom with tulipmania or the South Sea Bubble. The crash, of course, was invariably described as an innate feature of capitalism, except if it happens under a Republican president: then it's his fault.

What was special about the 1960s economy, and particularly 1968? Is it because that was the year that that saw the first budget surplus since 1958. I think journalists were trying to remind us that this happened under Democrats who controlled not only the White House but both other Houses. No doubt with this fact in mind they also recalled the period 1961-1968 that experienced the longest uninterrupted economic expansion in American history.

Also pointed out is that more Americans than ever held stocks in 1968. It's as if these politically motivated hacks are trying to paint the Democrats as the party of financial prudence and good economic management while excusing excesses and failures on capitalism. "It's not our fault! It's the system! What is missing from this rosy picture is the money supply -- the key factor and the one that is generally overlooked by media commentators as well as many who ought to know better. Examining the monetary situation in the 1960s will cast, I believe, further light on what happened during the 1990s as well as what is happening under the present administration.

The tail-end of the Eisenhower administration experienced a monetary tightening that brought on the 1960-61 recession, which also contributed to a Kennedy victory. Though the monetary breaks had been tightened they were quickly released in 1960 causing a monetary surge. This had the effect of stimulating output. However, the monetary breaks were slapped on again bringing monetary growth to a standstill by the end of 1961. The squeeze was so tight that money supply actually contracted in the third quarter of 1962. Needless to say, the economy faltered in the first half of 1962 and had definitely slowed in late 1962 and into early 1963.

To counter the recession that was emerging at the end of the Kennedy administration interest rates were forced down and monetary growth accelerated. All of which seemed to do the trick. From 1963 GDP grew by 5 per cent and unemployment fell below the 5 per cent level. (Does any of this sound familiar?)

In late 1964 money supply slowed only to be offset by another burst of monetary growth in 1965 as the Reserve sought to fend off rising interest rates through buying government securities. To avoid the inflationary consequences a credit squeeze was implemented in 1966 which was quickly followed by another monetary burst which in turned fuelled the budget surplus. Once again the breaks were applied and monetary growth dropped to 2 per cent. By 1969 the economy was in recession.

The obvious thing is that the 1960s expansion was certainly not the smoothly running boom that so many have come to believe. More importantly, however, is that the economic fluctuations were caused by a roller-coaster monetary policy. The lesson: Money matters. But money is exactly what is missing from the current debate, along with any meaningful grasp of capital. What marked out the 1990s monetary boom is the absence of severe fluctuations in monetary policy that characterised the 1960s. The Fed simply kept on pouring the booze, in the form of credit, into the party goers.

But sooner or later every party has to end, and the 1990s boom was no exception, with the result that one hell of a lot of people woke up with a financial hangover. I fear the same thing is happening again. From January 2006 to the end of December 2007 the money supply, meaning bank credit, has been completely flat*. I think this explains the collapse of the house boom, the slowdown in economic activity and the plunge in the stock market. These stock market are not acts of God and they are not the product of "defective markets". Machlup rightly pointed out that a stock market boom requires a continuous flow of bank credit. In other words, credit expansion. Therefore a

... continual rise of stock prices cannot be explained by improved conditions of production or by increased voluntary savings, but only by an inflationary credit supply. (Fritz Machlup The Stock Market, Credit and Capital Formation, William Hodge and Company Limited, 1940, p. 290).

What we are still suffering from in the media is the pundits' inability to distinguish between the descriptive and the analytical. There is no excuse for stupidity masquerading as sophisticated thinking once we consider how much these hacks are paid to 'inform' the public about economic matters.

*I omitted time deposits because I assumed they are straightforward credit transactions. This means that to include them in the money supply would be double-counting. It is for this reason that CDs should not be counted as part of the money supply. However, if time deposits became de facto demand deposits, i.e., a situation where these deposits exceed the amount actually lent to the banks, they would have to be included in the money supply. For example, if the total amount placed in time deposits was x dollars and the banks loaned out 10x dollars against these deposits, then we have a clear case of credit expansion.

I have to confess that I have not taken a close look at how the US banking system handles time deposits.

Gerard Jackson
BrookesNews.Com

Gerard Jackson is Brookes economics editor.

Copyright © 2005-2008 Gerard Jackson

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