widely respected economic commentators, Harvard’s Niall Ferguson and
Nassim “black swan” Taleb, have offered highly pessimistic assessments
of what lies ahead for the American economy.
Information like this is widely ignored by investors in weeks when they have decided that nothing can stop them: they will get rich by investing in the American stock market, no matter what. On July 21, Ben Bernanke told the Senate Banking committee that “the economic outlook looks unusually uncertain.” Stocks fell sharply as soon as he gave his testimony. But the Dow Jones Industrial Average recovered at the opening bell the next day, and then rose by almost 400 points over the next three business days. There was no news that countered Bernanke’s assessment. Investors simply shrugged it off.
Niall Ferguson is a professor of history at Harvard University and is also on the faculty of the Harvard Business School. This indicates that he has successfully jumped through the most rigorous of academic hoops. Because he writes voluminously and well on topics related to national finance, he is often asked to speak at high-level business conferences. He is a good speaker.
Ferguson recently was asked to write an article for London’s Financial Times. He began his article with a comment on the present state of debate over fiscal policy in the West. He said that the debate is depressing. I could not agree more.
He quoted the famous aphorism regarding the restored king of France after the defeat of Napoleon in 1815. The king was an heir of the Bourbon family. It was said that the family forgot nothing and learned nothing.
The same could easily be said of some of today’s latter-day Keynesians. They cannot and never will forget the policy errors made in the US in the 1930s. But they appear to have learned nothing from all that has happened in economic theory since the publication of their bible, John Maynard Keynes’s The General Theory of Employment, Interest and Money, in 1936.
With respect to
their assessment of those policy errors, his statement is correct.
But we should not be like the Keynesians, who have never understood
the policy errors of the Federal Reserve System and the Bank of England
in the second half of the 1920s.
The British government, following the advice of Winston Churchill, who was Chancellor of the Exchequer, in 1925 restored the gold standard at the pre-World War I ratio, despite the fact that the wartime monetary inflation had driven up the price of goods. Gold should not have been priced at the pre-War price. But Churchill had decided that national pride was at stake. He pretended that the debasing of the pound sterling had not been government policy.
There was an outflow of gold from the Bank of England. Speculators thought the price of gold in pounds would have to be officially hiked. To keep this outflow from forcing the Bank of England to suspend payment, thereby confirming the forecasts of the speculators, the head of the Bank of England met with the head of the New York Federal Reserve in 1926 and persuaded him to inflate the dollar, so as not to make the dollar too valuable in relation to the pound. This would have caused investors to sell pounds and buy dollars. The U.S. government would then have sent pounds to Britain and asked for payment in gold. The New York FED did what the Bank of England asked. It inflated the dollar. The result was the stock market boom from 1926—1929.
The head of the New York FED died in 1928. His successor recognized that a stock market bubble was in process. The FED ceased inflating. Short-term interest rates rose. This popped the stock market bubble in October of 1929.
The government then intervened. It raised tariffs. It began massive deficit spending. It began to interfere with pricing, so as to keep prices and wages high. In short, it adopted Keynesian policies, which made the economy much worse. This has been chronicled in Murray Rothbard’s 1963 book, America’s Great Depression. It has been steadfastly ignored by Keynesians ever since it was published.
The supposed policy error was the Federal Reserve’s refusal to inflate the monetary base in 1931 and 1932. This was Milton Friedman’s assessment in his book, A Monetary History of the United States (1963). It was hailed as a masterpiece by academia, meaning Keynesian academia. It won Friedman the Nobel Prize in economics. (Co-author Anna J. Schwartz, who did the hard statistical work, did not win a prize. But she is still alive, still going to work every day, so that’s a kind of reward.)
First, why are Keynesians still in love with a book by an officially anti-Keynesian author? Because it blamed the Federal Reserve System for not inflating, not the government, which had adopted policies that Keynes recommended years later.
Second, the Federal Reserve did inflate in 1932, as the charts reveal.
What offset this was the continuing collapse of banks. When the FDIC was created in 1934, the contraction of money ceased. This is not part of the Keynesian account of the Great Depression.
So, what the Keynesians never forget is their version of the policies of the Great Depression, which has never had much to do with the economic facts.
In its caricature form, the debate goes like this: The Keynesians, haunted by the spectre of Herbert Hoover, warn that the US in still teetering on the brink of another Depression. Nothing is more likely to bring this about, they argue, than a premature tightening of fiscal policy. This was the mistake Franklin Roosevelt made after the 1936 election. Instead, we need further fiscal stimulus.
What happened in mid-1936 was a stabilizing of the monetary base, as the chart reveals. This flattening of the base continued through 1937. It was not a fiscal policy error that brought back the second phase of the recession. It was Federal Reserve policy, which was to keep price inflation at bay. Think “the FED under Bernanke, 2006—2007.”
Ferguson summarized the contemporary debate over fiscal policy. Keynesians say of the Federal deficit, “no problem.” Why not? Because T-bond rates are low. There is no price inflation on the horizon. Anti-Keynesians argue that the recession is holding down T-bond rates and price inflation. Interest rates can reverse rapidly.
Ferguson did not mention the Austrian School’s explanation: a quest for safety (T-bonds) in an economy still facing a double-dip recession. The Federal deficit need not result in inflation; it can result in crowding out: government’s absorption of the investment capital that would otherwise have gone into private production. Federal Reserve policy is the source of inflation, not fiscal policy.
Keynesians, Ferguson said, deny that bond vigilantes even exist. In contrast, Ferguson’s colleague at Harvard, Robert Barro, denies that the Keynesian multiplier exists. Fiscal deficits do not stimulate the economy through the so-called multiplier effect. I am with Barro. Henry Hazlitt refuted that theory in 1959 in his book, The Failure of the ‘New Economics.’
Then he made an important point, one that has never gotten into the history textbooks or the economics textbooks.
When Franklin Roosevelt became president in 1933, the deficit was already running at 4.7 per cent of GDP. It rose to a peak of 5.6 per cent in 1934. The federal debt burden rose only slightly — from 40 to 45 per cent of GDP — prior to the outbreak of the second world war. It was the war that saw the US (and all the other combatants) embark on fiscal expansions of the sort we have seen since 2007.
The war led to massive monetary inflation by the FED, which bought U.S. bonds, which financed the war. This policy was accompanied by price and wage controls, which led to consumer goods shortages. Consumption fell. This lowered real wages. Then 12 million men were put in uniform and out of the labor markets. This ended the unemployment of the depression because it ended surplus production. Goods and services were consumed in a funeral pyre of death and destruction. Ferguson did mention this in passing: “. . . war economies worked at maximum capacity; all kinds of controls had to be imposed on the private sector to prevent inflation.”
So what we are witnessing today has less to do with the 1930s than with the 1940s: it is world war finance without the war.
We are, indeed. We are seeing massive fiscal deficits and massive expansion of the national monetary bases. But we are also seeing something resembling 1930—34: the collapse of banks. Bankers are terrified. They are holding excess reserves at the Federal Reserve. This keeps the fractional reserve process from converting a doubled monetary base into doubled M1 and doubled prices. The bankers fear losses. They did in the early 1930s.
So, this is a combination of wartime finance and early 1930s finance. This combination has reduced monetary inflation. This is why T-bond rates are low.
The bond vigilantes still exist, ready to lynch anyone who crosses them. But with private demand for loans low because of the uncertainty that Bernanke mentioned, the crowding-out phenomenon is not visible. It still exists. The money has to come from somewhere. If T-bonds are purchased, other investment assets are not. But we do not see rising interest rates. Rates have not fallen even lower because private firms at the local level are unable to get loans from local banks.
Today’s war-like deficits are being run at a time when the US is heavily reliant on foreign lenders, not least its rising strategic rival China (which holds 11 per cent of US Treasuries in public hands); at a time when economies are open, so American stimulus can end up benefiting Chinese exporters; and at a time when there is much under-utilised capacity, so that deflation is a bigger threat than inflation.
Here, his tools of analysis fail him. Price deflation is no more a threat than emergency surgery is when someone has gangrene. Price deflation is the readjustment of prices to reflect the true conditions of supply and demand. But his outlook is universal, except inside Austrian School circles.
Ferguson pointed to previous periods in which governments ran huge deficits that were financed by foreign investors. But these were weak national governments. He mentioned Argentina and Venezuela. The common term is “banana republics,” but he neglected to use it. He did remind us what happened.
The experiments invariably ended in one of two ways. Either the foreign lenders got fleeced through default, or the domestic lenders got fleeced through inflation. When economies were growing sluggishly, that could be slow in coming. But there invariably came a point when money creation by the central bank triggered an upsurge in inflationary expectations.
He has been giving speeches and writing articles for two years on this possibility for the United States. No other major academic figure/media figure has said this so forcefully.
He identifies Krugman as a Keynesian who fails to understand that fiscal deficits change people’s expectations. They figure out what has been done to them by Keynesian politicians. Then they figure out what is going to happen to their futures.
According to a recent poll published in the FT, 45 per cent of Americans “think it likely that their government will be unable to meet its financial commitments within 10 years.” Surveys of business and consumer confidence paint a similar picture of mounting anxiety.
He believes that we are fast approaching the end game. What is needed is a change of policies that restores private-sector confidence. While he did not say so here, he thinks the West is running out of time to adopt such new policies.
Nassim Taleb has updated his famous book, The Black Swan. The book deals with improbable events that disrupt systems, especially economies. These events cannot be predicted specifically, but they happen inevitably.
I argue that they happen because of debt leverage that is fostered by central bank monetary policy. But I agree with his point.
The problem is that citizens are being led to invest in securities they don’t understand by people who themselves don’t quite understand the risks involved. The stock market is probably the best thing in the world, but the true risks of the stock market are vastly greater than the representations.
This is the situation we face today. There is optimism, despite the obvious fragility of the economy.
“Companies have a tendency to hide risks.” He is correct. I add that governments have an even greater tendency to do this. Most of all, central banks do.
So someone extremely careful and prudent in the management of his own affairs will be completely careless with the half of his savings invested in the stock market. I’m saying: Don’t use the stock market as a repository of value. It has vastly more risks than you think.
I second the motion. But fund managers do not heed this advice, he insists.
He has offered one of the best pieces of advice I have seen from any best-selling author of a book on finance.
We have this culture of financialization. People think they need to make money with their savings rather with their own business. So you end up with dentists who are more traders than dentists. A dentist should drill teeth and use whatever he does in the stock market for entertainment.
He thinks people should own their own businesses. He says they should invest on this assumption: inflation is coming.
He warns against government deficits.
The problem is getting runaway. It’s becoming a pure Ponzi scheme. It’s very nonlinear: You need more and more debt just to stay where you are. And what broke [convicted financier Bernard] Madoff is going to break governments. They need to find new suckers all the time. And unfortunately the world has run out of suckers.
Your loud-mouth brother-in-law probably doesn’t believe any of this. Your aged parents may not believe. Surely, the typical Congressman doesn’t believe it. But you had better believe it . . . and then act in terms of it.