Alasdair Macleod – 23 July 2009
They fail to improve things for the private sector.
Very few people take the view that the current recession is a slump on the scale of the Great Depression of the 1930s. However, a dispassionate examination of the facts produces an alarming conclusion: with current government policies it is shaping up to be worse. Eighty years ago, the US ran a trade surplus; today it has a huge deficit, ensuring that all countries are tied into America’s troubles.
The credit bubble in this decade was mostly fuelled by the Fed’s monetary policy in the wake of the dot-com collapse. This bubble compares neatly with the credit bubble of the late 1920s, when the Fed pumped credit into the loan market, driving down interest rates from their free-market level. In 1927 the discount rate was then lowered to help save Britain’s gold reserves. That bubble was further fuelled by the Fed’s desire to develop the new acceptance market, when the Fed bought nearly half of all acceptances held, flooding the market with commercial credit. The aggressive development of the acceptance market was an event comparable with the development of the shadow banking system in recent years. At the same time as the US was creating its recent credit bubble, other central banks such as the Bank of England were making the same monetary mistakes.
So the monetary run-up to today’s crisis has too many similarities to dismiss lightly, more of which below. On the fiscal side, the situation today is far worse than then. Between 1930 and 1932 President Hoover increased federal spending by 42%, turning the federal surplus of 0.8% into a deficit of 4% of GDP. The figures today are considerably worse with bail-outs and an accelerating budget deficit exceeding 20% of GDP this year. The Keynesians will doubtless justify this largesse by claiming that the private sector is not capable of recovering without government help, so their answer is to provide as much as may be required.
There are several key reasons why increased government spending cannot work and will make things worse. They are:
- Government borrowing is now so great that there has to be a substantial and prolonged shift from consumption to savings to finance it. While a shift to savings after a period of excessive consumption is desirable and natural, this will rule out a consumption-led recovery for many years. Furthermore, this suppression of a diminished private sector may ensure that government deficits will perpetuate themselves so long as this policy is followed.
- All governments are facing the same difficulties. There is therefore no external means of engendering a recovery. To understand the importance of this point, consider how bad it would have been for Japan in the 1990s if it had had no export markets.
- All governments are adopting the same Keynesian policies, leading to sky-rocketing borrowing by them all at the same time. This is bound to drive up nominal interest rates with the result that the interest burden of this borrowing is seriously under-estimated, and the private sector will be excluded from credit markets.
- Government spending is the least efficient means of deploying a nation’s resources. Using the UK education system as proxy, in my note dated 19th June I demonstrated that this inefficiency loses as much as 40% through inefficiencies. Put simply, the Keynesian approach takes taxpayer’s money and wastes it when the taxpayer is least able to afford it.
- A government’s principal objective is to alleviate employment in the private sector by supporting businesses that need to shed it. Intervention therefore extends the adjustment process expensively and unnecessarily.
In mild recessions, these contradictions are not so apparent, but when a slump of significant degree occurs they defeat the objective. Furthermore, the private sector is now becoming the smaller of the two and is being swamped by the public sector, so its inherent ability to develop its recovery through the public sector’s command structure is less today than it was eighty years ago.
Monetarism doesn’t work either.
The monetarists advocate printing money in order to achieve “price stability”, a solution that is equally flawed. Behind this approach is a fear of falling wages and prices, which arose from the Great Depression and Keynes’s analysis of its consequences. This analysis, which is now universally accepted, concludes that the depression was exceptionally severe and long-lasting because of deflation, and the gold standard being the villain behind it all.
An examination of the facts offers a different conclusion. There was vast credit expansion throughout the 1920s. This was given a further twist by the Fed when it lowered interest rates in 1927 to take pressure off the Bank of England. At that time, inflationary policies led to an outflow of gold from Britain to America, and the Fed sought to counteract this flow by adopting more inflationary policies itself. Inevitably, interest rates had to rise subsequently in 1928-9, triggering the collapse of the credit bubble.
The cause of the problem then as now was an irresponsible expansion of credit. When a credit bubble collapses, borrowers and lenders need to reconcile their positions. The proposition behind quantitative easing is to somehow ease this process by providing a background of price stability. For this to be true assumes that borrowers and lenders can be persuaded to defer their reconciliations and work them through over time.
Again, history tells us otherwise. In the 1930s, the Fed tried unprecedented measures to encourage bank lending, but the fact was that banks saw too much risk in lending. When the Fed bought government securities, the banks deposited the money back at the Fed. They did this rather than lend to other banks because frightened depositors would withdraw funds to hold physical cash, since banks were going bust. The safest place for money was in folding notes, and each note so held reduced the ability of the banks to lend another nine, so the Fed was powerless to halt the credit collapse.
The problem is different in one respect today, in that governments generally guarantee bank deposits, but this is still not enough to stop the contraction of bank lending. The banks face severe pressures on their base capital due to rising bad debts and falling asset values. Starting from unprecedented levels of balance sheet gearing, banks have no alternative to calling in loans. The effect is exactly the same as having frightened depositors withdrawing their deposits.
The monetarists’ proposition amounts to a redistribution of resources from savers to borrowers by using the printing presses. It is hard to see how this can resolve the dark side of the credit bubble, unless monetary inflation becomes so severe that it collapses the real value of outstanding debt. Furthermore, there were no long-lasting slumps prior to the Great Depression, suggesting the gold standard is a better servant of the economy than central bank intervention.
There is also evidence that a sound monetary stance at times of difficulty produces better results. In 1920 the Fed raised the discount rate at the height of the 1920-21 post-war depression to the then record level of 7%. The result was the economy corrected itself considerably more quickly than otherwise would have been the case, and by 1923 unemployment fell from a peak of 11.7% to only 2.4%. In comparison, in 1930 the discount rate was lowered to a record low of 1½% and unemployment rose from 8.9% in 1930 to 24.9% in 1933. Unemployment only fell below 10% in 19 41, eleven years after easy money was meant to rescue the economy.
So artificial pricing of money and quantitative easing do not fool the markets, they only delude the economists. There is a natural market rate for the cost of money, and to manipulate it as central banks do produces unexpected results. We know that messing with markets is a bad idea: it is hard to find any intelligent economist to support, say, EU intervention in agricultural markets, yet the same person will automatically assume financial intervention is somehow different; it isn’t. The evidence is that these monetary policies make things considerably worse by distorting credit markets.
The world of economists and central bankers is firmly convinced that by ratcheting up fiscal and monetary intervention salvation will follow. A close examination of the facts shows the obverse is the likely outcome, and the more they reflate the worse the slump will be. On this basis alone, the current slump will be worse than the Great Depression.
Governments will almost certainly go the extra mile to screw it up further. They are beginning to realise that there is a limit to their budget deficits. We know that the public sector needs to be radically cut, but governments are more likely to hike taxes. This was precisely what Hoover did in 1932, when the top rate of income tax was raised from 25% to 63%, and the lowest rate from 1.5% to 4%. Burdening the private sector with the unwelcome cost of government folly did not work then, nor will it work now.
We can conclude that this slump may be worse than that of the Great Depression, because the imbalances are greater, and there is a determination to pursue fiscal and monetary intervention to destruction. This slump will last at least as long unless interventionist policies are abandoned, so we are faced with perhaps ten to twenty years of depression. Oh, and as if that was not enough, this slump is running into the demographic time-bomb of the pensions’ Ponzi scheme, due to hit us in the next ten years or so.