America's credit crunch — we've been there before
Gerard Jackson
It's credit crunch time for the US economy and — as I have predicted so many times — the free market gets blamed. For socialist fanatics like Christine Milne and Professor Quiggin the thought that we are witnessing a gross failure of interventionism is an anathema. For the likes of him it is an article of religious faith that the free market is doomed by its inner contradictions, despite the fact that the Austrian school provided a devastating critique of socialism and interventionism that no socialist has ever refuted.
We also have the interventionist likes of Anatole Kaletsky (associate editor of the London Times) who smugly stated that "market failure is fundamental to any understanding of banking crises". Wrongheaded does not due justice to Kaletsky's ignorance. I have lost count of the number of times I have had to point out that the economic commentariat — including academics who insist on sharing their economic wisdom with the rest of us dummies — always manage to ignore the glaring fact that every financial crisis is preceded by credit expansion.
The sequence is simple: credit expansion is accelerated, a boom follows in which the prices of various assets take off followed by a credit crunch and a financial hangover. Yet the likes of Quiggin and Kaletsky completely overlook this sequence, despite the fact that it was known to earlier economists and discussed at length. (This is a fascinating story in its own right). No wonder I despair of the public ever being properly informed about economic matters.
To put to rest the calumny that the Austrians are always predicting doom without putting forward an economic analysis I think I shall begin with 1914, even though this means covering some old ground. From June of that year to June 1920 the money supply1 rose from $16 billion to just over $34 billion. Faced with a monetary figure of this magnitude an Austrian would predict a boom followed by a bust once the monetary brakes were applied. And this is exactly what happened.
In an effort to bring the situation under control the Federal Reserve raised the discount rate to 6 per cent in January 1920 and to 7 per cent June. The boom broke and the 1920-21 financial crisis struck. If you think things look grim today you should have been around then. The index number for wholesale prices stood at 98.2 in 1914 (1913=100) from which they rose to 227.9 in 1920. A credit crunch halted the boom causing the index to plummet to 148.3 by 19222. (Incidentally, though this was the fastest and biggest price drop in US history unemployment only rose to 11 per cent).
About 12 months later the money supply once again began a rapid expansion, rising from $33 billion in June 1922 to $40 billion in December 1924. However, in 1924 the economy began to slowdown in response to the serious malinvestments caused by the monetary expansion. To avert a recession the Federal Reserve lowered the discount rate three times.
From December 1924 to December 1928 money supply rose from $40 billion to about $46.5 billion, at which point the reserve halted further expansion causing industry to start shedding labour in the following July. The 1929 July index for wholesale prices was 100. By February it had dropped to 62. During the same period the money supply shrank by about 35 per cent. The refusal of the Hoover and Roosevelt administrations to allow costs to adjust to the monetary conditions it what gave America the Great Depression.
The same pattern of economic disturbances emerged after WW II. From about 1958 to 1978 the money supply doubled3 while the period from about 1982 to present saw the money supply zoom, growing by about 500 per cent. The monetary chickens have now come home, giving statists and socialists the opportunity to blame the free market instead of the lousy economics that they themselves preach as being sound. (I predicted this four years ago US economy: storm clouds ahead)
What the public needs to understand is that the crisis was made unavoidable by bad economic economics. The kind of economics that thinks monetary expansion is necessary for the maintenance of economic growth.
*The original figure had been 700 per cent. This was due to a typing error on my part.
1. Currency outside commercial banks, demand deposits or checking accounts of and time deposits of commercial banks.
2. The boom was not continuous, being punctuated by several 'stop-go' episodes.
3. Of course, the money supply did not grow at a fixed rate. It never does.
Gerard Jackson is Brookes' economics editor
BrookesNews.Com
Monday 29 September 2008