Why the congressional bailout won't solve the credit crisis
Gerard Jackson
Congress just saved America from another Great Depression — or did it? The economic commentariat and congressmen are as ignorant about the causes of the Great Depression as they are about the current financial mess. The fact that both were caused by the Fed's gross monetary mismanagement is something of which they are blissfully ignorant. The thought that these historic events were monetary disorders created by the Fed and not some mysterious disequilibrating force that is inherent in capitalism seems too deep for them or their economic advisors to grasp. (Unfortunately, the same problem exists in Australia).
Let's take a look at what is passing for intelligent economic commentary. We were told that if Congress did not act the economy would sink into recession. Yet none of these commentators explained why this would happen. Instead of an analysis they keep making references to the Great Depression. If that is going to be the linchpin of their argument then we should make it our starting point. That great turning event in history was by a serious monetary expansion. It was this expansion that fuelled what is now called the "roaring twenties".
In 1924 it was clear that the economy was slowing. The Fed responded by giving it another monetary injection. By 1928 the Fed had become deeply concerned about the boom and the speculative fever that was driving the stock market to ever-increasing and unsustainable heights. So in December of that year it froze the money supply. Nevertheless the banks still kept the stock market booming by encouraging depositors to put their money into time deposits. (Despite their name depositors as a rule did not have to wait before withdrawing their money).
These accounts had a reserve ratio of only 3 per cent*, hence the eagerness of the banks to have their clients move their savings into them. Nevertheless, it was only matter of time before the ability to fund increased speculation was brought to an end. In the meantime, the monetary squeeze was making itself felt on the 'real economy'. By July it became clear that manufacturing was contracting. It also became clear to those in the market with decades of experience behind them that the party was over. In October the market crashed.
Even though industrial indicators were pointing to a recession long before Black Thursday struck our economic commentators still insist on pointing the finger of guilt at the speculative frenzy that marked the last days of the stock market boom. They have never asked themselves where all the credit came from that fuelled the frenzy. Nineteen-thirty was marked by the beginning of an unprecedented wave of bank failures that continued into 1933. The result was a massive deflation that saw the wholesale price level (1929 July=100) drop to 62 in February 1933, after which it began to rise.
This brief historical survey points to gross monetary mismanagement by the Fed as being the real problem. What the commentariat calls a problem is in fact a symptom of a monetary disorder.
It's preposterous to think that America is teetering on the brink of an economic disaster triggered by a massive wave of bank failures brought on by nervous depositors withdrawing their funds. Apart from the fact that the Fed stands by as an unofficial lender of the last resort, the banking system is very different today from what it was in the 1920s, and the banking public is not lining up outside the banks waiting for them to open their doors. Furthermore, there is nothing new about bank failures in the US. Before the crash a number banks failed each year without bringing the system to its knees.
Banks are like other businesses. If one gets into trouble there are always others prepared to move in and buy up whatever assets are available. In these cases there is no reason why a general run on banks should eventuate. For example, Wells Fargo has made a $15.1 billion bid for Wachovia which in turn has brought howls of protest from Citigroup. There are more stories of financial institutions making similar takeover moves. (Leftwing critics would call them "sharks" or "predators").
While there is nothing here that suggests an impending deflation there is plenty of circumstantial evidence that inflation will be the devil to look out for. Last week the Fed released its balance sheet which showed that its assets had grown from $1 trillion to $1.5 trillion. It seems that the extra $500 billion represents mortgage backed securities. I take this as strong evidence that the Fed will not allow a financial collapse, which is not the same thing as saying it will save every financial institution goes on the skids.
Martin Feldstein argues in the Wall Street Journal that the existence of "some 10 million homes with mortgages that exceed the value of the house" will block the flow of "liquidity" to the banks. (The Problem Is Still Falling House Prices , 4 October 2008) The thinking here is that
The prospect of a downward spiral of house prices depresses the value of mortgage-backed securities and therefore the capital and liquidity of financial institutions.
But the value of a mortgagor's home does not determine his ability to meet his repayments. That is determined by his income. To have the value of one's home drop by 20 per cent is not a pleasant experience. However, it needs to be remembered that people buy houses in order to make a home for themselves. Therefore so long as the ability and willingness to make payments continues the bank has nothing to worry about on that score. And it is indisputable that millions of Americans are doing just that — making payments, regardless of whether or not the market value of their homes has dived.
The only way that Feldstein's nightmare could become reality is if all of these mortgage-bound Americans became unemployed. A further point that needs stressing is that it does not matter from a monetary perspective if the value a great many "mortgage-backed securities" falls. What matters in these circumstances is what happens to the quantity of money. (Feldstein's opinion brings to mind the wealth effect fallacy).
Dr Shostak made the interesting observation that the congressional rescue package could damage the economy by keeping float various financial firms who should never have come into existence in the first place, (Can congress save the US economy from recession?). It ought to be plain that the more an inflationary boom stokes a speculative frenzy the more resources will have to be diverted to serve it.
Fortunately the Weimar inflation provides an excellent, though extreme, example of this happening. In 1914 the number of newly-opened banks was 42; in 1923, at the height of the inflation, there were more than 400. Employment in this sector grew from 100,000 in 1914 to about 380,000 in 1923. (William Guttmann and Patricia Meehan, The Great Inflation, Saxon House. D.C. Heath Ltd., 1975, p. 193). Constantino Bresciani-Turroni reported that the stabilisation policy that brought the hyperinflation to an end brought about the discharge of over 100,000 bank employees who were no longer needed. (Constantino Bresciani-Turroni, The Economics of Inflation, John Dickens & Co Ltd, 1968, p. 391).
Finally there is the post-WW I lesson of Japan. The war-time boom had caused an accumulation of imbalances (malinvestments). In 1920 the economy crashed and the price level droped, but not far enough. Rather than allow the depression to liquidate the malinvestments Japan tried to arrest the process and save its banks and other financial institutions. Hence Japan was kept in depression for seven long years, years filled with political instability and rising militarism.
Then in 1927 the internal contradictions of this policy were finally resolved by what was probably the severest financial crisis in Japanese history. The crisis brought down industries and wiped out many branch bank systems. This was followed by about 18 months of consolidation that unfortunately helped build Japan's war machine. Thus ended Japan's first New Deal policy, all because she did not follow the American example of the time and allow market processes to fully liquidate her unsound investments and eliminate excess inventories. The irony here is that Hoover and Roosevelt basically implemented the same policies that post-war Japan did, without, fortunately, the same political consequences.
The real problem, and one Congress will never solve, is one of lousy economics and an equally lousy understanding of economic history as well as the history of economic thought.
*The reserve ratio of 3 per cent did not turn these deposits into checking accounts, meaning there was no multiplication of deposits as is the case with checking accounts.
Gerry Jackson is Brookesnews' economics editor
BrookesNews.Com
Monday 6 October 2008