Economic
Warnings From Two Respected Analysts By Gary North | July
28, 2010
Two
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.
TALEB'S CONFORMATION
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.
CONCLUSION
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.