The Bush economic boom is going to teach us another lesson
Gerard Jackson
Already some economic commentators are talking about President Bush's boom and how it will exceed Clinton's boom. This view demonstrates that when it comes to economics and economic there is a remarkably flat learning curve.
Let's take quick look at the Clinton economy. Media commentators at the time claimed that "the economy has entered a new era", others claimed that a "new epoch in economics" had arrived. These Pollyanna statements were not isolated headlines designed to grab readers' attention but the result of an inability to understand what was happening to the American economy.
Unfortunately, in this respect these commentators only parroted sentiments that seem to dominate the economics profession. Yet there was nothing new here. The great American boom of the 1920s was also hailed as a "New Era", one, so it was thought, that heralded permanent prosperity for the American people.
A stable price level and booming output persuaded the likes of Keynes and Professor Fisher that a New Era had indeed arrived, with Keynes describing Federal Reserve Board monetary management as a "triumph" — a triumph whose economic and political denouement was the Great Depression. (Though Fisher was later ridiculed for his optimism, Keynes was praised for his 'wisdom'. There just ain't no justice in this world).
During the 1920s investment in the capital structure of about 6.4 per cent a year caused manufacturing productivity per worker to rise by 43 per cent while prices remained relatively stable.
By 1929 America was producing virtually as many cars as in 1953, the sale of electrical products tripled, spending on radios rose from about $10.7 million dollars in 1920 to more than $411 million by 1929, a prolonged building boom provided millions of Americans with their first house.
That the period was marked by rapidly rising consumption was not disputed. There was, however, a dark side to this success story. Despite the rise in productivity many workers found it difficult to maintain their purchasing power. The increasing movement of married women into the workforce at this time tends to lend support to this view.
Though the 1920s is considered by some to be the greatest boom period in US history the greatly neglected boom of 1896-1903 exceeded it, certainly in terms of physical production though not in financial folly.
Statistics show that nearly half of the rise in productivity during the 1920s took place from 1921 to 1923. US Bureau of Labor Statistics revealed that average real wages (excluding agriculture) rose by just over 6 per cent from 1921 to 1929. Needless to say, this average concealed considerable differences in pay rates.
What happened was that the attempt at price stabilisation skewed consumption and created an imbalance in production. (What the Austrian school would call misdirected production or malinvestments.) The rapid progress in productivity should have seen the price level gently decline.
Persuaded by the likes of Fisher, Gustav Cassel and Ralph Hawtrey that allowing prices to fall was bad for the conomy, the Federal Reserve engaged upon massive credit expansion by forcing down the discount rate.
The result was that though the number of dollar bills remained comparatively stable ($3.68 billion in 1920 compared with $3.64 billion in 1929) credit grew from $45.3 billion in June 1921 to $73 billion in July 1929, a 61 per cent rise.
It was this rapid expansion that fuelled the stock market frenzy and created malinvestments by discoordinating the market process. However, by the end of 1928 the inflation was over. Total money supply stood at $73 billion on December 31, 1928 and $73.26 billion on the 29 June 1929. The result was inevitable.
One argument advanced in support of the price stabilisation doctrine is based on the fallacy that any general fall in prices is by definition deflationary and will thus depress business activity and raise unemployment. This view makes no distinction between a money induced fall in prices caused by a monetary contraction and falling prices caused by rising productivity.
Nonetheless, The Australian Financial Review could seriously argue (14/9/98) that the period 1870-90 was a deflationary one in the US and that it was "excess capacity" that drove prices down while "production boomed". It evidently did not occur to the author that booming output is incompatible with 'excess capacity.' Moreover, he admitted that falling prices were caused not by a monetary contraction, i.e., genuine deflation, but by increasing investment — thus demonstrating how rife confusion is on this subject.
What is obviously not understood is that falling prices due to increased productivity benefits everyone by spreading the fruits of increased investment. Attempts to stabilise the purchasing power of the monetary unit blocks this process. This process denies many workers the increases in real incomes that they would have otherwise enjoyed. And this is precisely what happened during the 1920s boom.
Credit expansion caused wage rates in the capital goods industries to significantly outstrip those in the consumer goods industries. By expanding credit capitalists were encouraged to invest in lengthier and more complex stages of production causing them to bid up wage rates at the expense of those in the consumer goods industries.
In addition, because the means (capital goods, i.e., savings) were not available to finish these stages1 they eventually revealed themselves as malinvestments, misnamed 'excess capacity'.
Put another way, labour employed in the capital goods industries had the value of its services inflated by credit expansion, which in turn allowed it to bid more goods away from other workers.
It should also be clear that the credit expansion imposed forced savings which kept real wages below the level that a genuine free-market saving/consumption ratio would have dictated.
And all for the sake of a so-called stable price level. No wonder Phillips, McManus and Nelson were driven to charge that "the end-result of what was probably the greatest price stabilisation experiment in history proved to be, simply, the greatest depression" (Banking and the Business Cycle).
Unfortunately it was the stock market frenzy that marked out the 1920s and became the culprit for the depression instead of credit expansion. The'90s stock market boom contained clearly defined shadows lurking from the financial follies of the Roaring Twenties.
By 1929 the average stock had tripled its value in only 7 years. Alarmed at the apparent inexorable rise of the market and the accompanying reckless speculation, Roger Babson, a Boston financial adviser, was warning investors in September 1929 of an imminent crash. (Babson was far from being a lone voice. Sound money men like Benjamin M. Anderson and E. C. Harwood also warned that a crash was inevitable.
In early 1929 Hayek published a number of articles in the monthly reports of the Austrian Institute of Economic Research, of which he was director, arguing that the boom only had months to run. Felix Somary, another economist in the Austrian school and Swiss banker, even warned Keynes against buying stock and predicted an impending crash. Keynes replied: "There will be no more crashes in our lifetime."
Convinced that the price level proved that there was no inflation, Irving Fisher argued that "stock prices have reached what looks like a permanently high plateau." In his paper Is There Inflation in the United States?, 1 September 1928, Keynes endorsed Fisher's optimism, only to admit in 1930 that he had been mistaken about inflation.
Yet we are hearing basically the same thing about the Bush economy. Given that the price level in the 1920s remained stable, I suppose many can be forgiven for thinking that inflation was absent. As we can see, even stable prices can conceal considerable inflation if we define inflation, as we should, as a monetary expansion.
It follows that economic observers should be looking at money supply figures for guidance and not price indexes. In this respect the signs are not good with the money supply rising sharply. From September 2002 to August 2004 M1 expanded by about 13 per cent. To monetarists and supply-siders this is a modest and probably necessary rate of recovery. To Austrians it signals another recession.
Cheap money advocates don't realise that it was this policy that created the 1920s boom that resulted in the Great Depression.
The freezing of money supply in December 1928 guaranteed a comparatively quick end for the boom. Austrians point out that even if monetary growth had continued the boom would have terminated itself.
With the Bush boom, as it was with the Clinton boom, the question is not if but when.
Gerard Jackson is Brookes' economics editor
BrookesNews.Com
Monday 20 September 2004