By the end of 1930, one in four wage earners was out of work. In one day in Mississippi, one quarter of the entire state was auctioned off. Prices of wheat and corn were so low, crops were left to rot in the fields. "Somebody had blundered," wrote F. Scott Fitzgerald, "and the most expensive orgy in history was over."
It was borrowed time anyhow -- the whole upper tenth of a nation living with the insouciance of grand ducs and the casualness of chorus girls. Even when you were broke you didn't worry about money, because it was in such profusion around you. Toward the end one had to struggle to pay one's share...Wars and depressions. Recessions, booms and busts. They're written about afterwards as if they're natural events over which man has no more control than we do over hurricanes and earthquakes, when they are in every way as man-made as a Monday morning hangover -- which is perhaps the very best metaphor for economic depression.
Now once more the belt is tight and we summon the proper expression of horror as we look back at out wasted youth ... when we drank wood alcohol and every day in every way we grew better and better and people you didn't want to know said "Yes, we have no bananas" -- and it all seems so rosy and romantic to us who were young then, because we will never feel quite so intensely about our surroundings any more.
Somebody has blundered, and we're paying for it again.
With every depression, with every hangover, if we have any insight we must look back and ask ourselves, "wha' happened?" and make sure we don't do it again. What happens instead however is we wake up saying something like "Ooh, never again!" -- and within the week we're back on the turps and gibbering again about bananas, whether we have them or not.
History repeats itself, but only if we're too dumb to learn. The pattern of the twenties was replicated over the last decade; the collapse is almost a repeat of the consequent disaster; and the bailouts intended to prolong our own orgy of the last few years replicates the bailouts of Herbert Hoover's abysmal administration.
They didn't work either.
But what caused the collapse of 1929? Like every monumental hangover, the collapse was inherent in the orgy. And like that one, those responsible for the monumental blunder are shucking off the blame, and seeking even more power to do it all over again.
Financially speaking, the twenties in the US were characterised by three things: the rise of the central bank to prominence and the idea that there was a "new era of prosperity" in the air; an era of easy credit, which helped to foster the idea that a "new era of prosperity" was in the air; and the single-minded pursuit of "price stability," which led to the pumping of the money supply and all that easy credit.
For almost the entire decade of the twenties, the Federal Reserve vigorously pursued a policy of "price stability." The grandaddy of all Fed Governors, Benjamin Strong -- the predecessor to Greenspan and Bernanke -- wrote in 1925,
that it was my belief, and I thought it was shared by all others in the Federal Reserve System, that our whole policy in the future, as in the past, would be directed toward the stability of prices so far as it was possible for us to influence prices.And again in 1927, when asked in that years "Stabilization Hearings," whether the Fed could "stabilize the price level" through open-market operations and other control devices:
I personally think that the administration of the Federal Reserve System since the reaction of 1921 has been just as nearly directed as reasonable human wisdom could direct it toward that very object.Sound familiar?
They aimed for "price stability," and they succeeded: Consumer prices and wholesale prices were stable for most of the decade. But they shouldn't have been. They should have fallen. Increased mechanisation, increases in scale and increasing productivity should have made prices fall. To keep prices up -- to keep them 'stable' -- The Fed had to inflate, and inflate and inflate again. In 1921, before their inflation of the currency began, the total American money supply was $45.3 billion. By July 1929, when the stock market first started to crack after a year-on-year expansion of the money supply (which in 1924 was as high as 11.6% !), it had exploded to $73.29 billion.
As economists CA Philips, TF McManus and RW Nelson said in 1937, "the end-result of what was probably the greatest price-level stabilization experiment in history proved to be, simply, the greatest depression."
That $28 billion, created out of thin air, had to go somewhere. Where it went, for the most destructive part, was into capital goods. Consumer prices and wholesale prices were stable, but the General Price Level (which included housing, commercial property, foods and farm products) rose considerably.
Just as in the twenties, so too over the last decade, where in order to keep consumer prices "stable," the money supply had to be inflated year-on-year to conceal by inflation the productivity effects of the internet age and and of the flood of cheaper consumer goods from Asia -- and the monetary inflation blew out first in the housing market. Just as in the twenties, so too in the 'Noughties,' the expansion of the money supply squandered real wealth and led to economic destruction. And so it has been every time the expansion of the money supply has been substituted for genuine prosperity, in the US and NZ just as surely as in Zimbabwe -- as this graph so clearly demonstrates:
We might write it as a general rule: Monetary expansion always cometh before a fall.
The flood of easy credit always has to blow out somewhere. Where it first blew out this time was the housing and mortage sector, and Jeff Perren starts a series today tracing the course of that particular sector of the disaster. (The first two parts are here and here.) But if you think, as George Bush and Ben Bernanke and Henry Paulson seem to think, that the blow-out will be contained to the housing and mortage sector, then you are even more deluded than we already have good reason to think they are.
As Frank Shostak pointed out yesterday,
The Bush administration is asking Congress to let the government buy $700 billion in bad mortgages as part of the largest financial bailout since the Great Depression. The plan would give the government broad power to buy the bad debt of any US financial institutions for the next two years. It would also raise the statutory limit on the national debt from $10.6 trillion to $11.3 trillion.Shostak is not alone in his analysis. The whole capital structure is contaminated, not just the housing and mortage sector. The easy credit has worked its way all through the capital structure like termites through your new home -- adding more weight to that structure when what producers need is to be left alone to restructure stick by stick will only extend the misery, and delay the necessary recovery.
At the root of the problem are not mortgage-backed assets as such but the Fed's boom-bust policies. It is the extremely loose monetary policy between January 2001 and June 2004 that set in motion the massive housing bubble (the federal-funds-rate target was lowered from 6% to 1%). It is the tighter stance between June 2004 and September 2007 that burst the housing bubble (the federal-funds-rate target was lifted from 1% to 5.25%).
Can the "rescue plan" fix the US economy, or will it plunge us into the mother of all recessions?
On account of the time lag, we suggest that the tighter interest stance of the Fed between June 2004 and September 2007 has so far only hit the real-estate market and financial institutions.
Various bubble activities that sprang up on the back of loose monetary policy between January 2001 and June 2004 are not only in the real-estate and financial sectors; they are also in the other parts of the economy.
Consequently, there is a growing likelihood that these activities will come under pressure in the month ahead regardless of the rescue package. Since these activities are the product of loose monetary policy, obviously the banks that supported them are going to incur more bad assets, which will put more pressure on banks' net worth.
Contrary to popular belief, the rescue package cannot help the economy; it will only severely weaken wealth generators. (The larger the package, the more misery it will inflict.) Hence, once the massive rescue plan is implemented, it will not prevent an economic slump but, rather, runs the risk of plunging the economy into the mother of all recessions.
And as for calls to regulate the "deregulated" capital markets, only a myopic drone could even take such calls seriously. As Michael Hurd points out in today's Washington Times:
I don't understand why the lesson of the recent financial meltdown is that we must return to regulation. The regulatory infrastructure we have today has been in place since the 1930s New Deal - and before.Even if either was economically literate, it would be impossible. And neither of them are.
This infrastructure was supposed to prevent such a meltdown from happening. The federal government guarantees everything. This transformed capitalism from a system in which all financial institutions are privately run - and financially responsible for their mistakes.
Deep down, business executives always knew they could appeal to the government if they made foolish decisions that cost untold billions - and that's exactly what happened.
Our mixed economy - neither capitalism nor all-out socialism since the 1930s - performed exactly as it's supposed to perform in the context of a heavily regulated market.
We could basically respond in one of two ways. One way would be to acknowledge the experiment in the mixed economy as a failure, refuse to bail out those who counted on the government to rescue them from their mistakes and evasions, and start clean with a private marketplace.
It would be painful, but there's no escaping pain after a mistake of this kind. The other alternative is what's happening now: to bail out most if not all of the failing institutions; to require American taxpayers to foot the bill; to nationalize and even further regulate what's left of the industry, where possible; and to remove still more - maybe even most, at this point - of the capital out of capitalism.
Sens. John McCain and Barack Obama don't fight over which direction in which to move. Fundamentally, they agree: We need more regulation, more government and less capitalism.
Fine. Will one of them please explain, then, how more of the system that brought us to this point is to rescue us suddenly?
UPDATE 1: Via Anti Dismal, Don Boudreaux wonders why, since the government's money supply policy is obviously so crash hot, we don't we have the same policy for steel supply. Good reading.
UPDATE 2: I am in receipt of an excellent letter to the editor of the NZ Herald, in response to their appalling editorial yesterday:
In your editorial of 23 September you refer to the US government’s bailout of the financial system as “rewarding the guilty” and then note that “… when markets fail, government is the only solution.” The only truly guilty party is the party to which you are now turning to for “solutions”.
Since the creation of the Federal Reserve in 1913, there has been a significant debasement in the value of the US dollar due to the unrestrained increase in the money supply by the Federal Reserve, i.e they have been printing money. Since 2001, this has manifested itself in a housing bubble, the recent bursting of which is a healthy recognition by the market that the real value of these assets is much lower.
The seeds of the current crisis were therefore laid many decades earlier with government intervention in the market. It is they who are guilty and they should not be rewarded with additional powers to intervene, actions that will lead to the further destruction of economic wealth.