31 October 2008

Avoiding a Great Depression: Rescue, Rebalance, Reform

The 1920's were marked by a credit expansion, a significant growth in consumer debt, the creation of asset bubbles, and the proliferation of financial instruments and leveraged investments. The Federal Reserve expanded the money supply and the Republican government pursued a laissez-faire approach to business.

This helped to create a greater wealth disparity, and saddled a good part of the public with debts on consumables that were vulnerable to an economic contraction.

The bursting of the credit bubble triggered the stock market Crash of 1929. The Hoover administration's response was guided by Secretary of the Treasury Andrew Mellon. As noted by Herbert Hoover in his memoirs, "Mellon had only one formula: 'Liquidate labor, liquidate stocks, liquidate the farmers, liquidate real estate.'"

Indeed, the collapse of consumption and credit, and the ensuing 'do nothing' policy of liquidation by the government crippled the economy and drove unemployment up to the incredible 24% level at the climax of the liquidation and deleveraging.

Although some assets fared better than others, virtually everything was caught up in the cycle of liquidation and everything was sold: stocks, bonds, farms, even long dated US Treasuries, all of them collapsing into the bottom in late 1932.

The Federal Reserve made tragic policy errors most certainly with regard to interest rates. They were hampered by a lack of coordinated effort because of the official US policy focus on liquidation and non-interference, along with mass bank failures which rendered their attempts to reflate the money supply as largely futile.

Thrifty management of the credit and monetary levels when the economy is balanced in the manufacturing, service, export-import, and consumption distribution levels is a good policy to follow.

But good policies applied with vigor during a period of economic illness may be like forcing patients seriously ill with pneumonia to swim laps and run in marathons because you think such physical activity is inherently good and beneficial in itself at all times.

Additionally, monetary expansion alone also does not work, as can be seen in the early attempts by the Fed to expand the monetary base without policy initiatives to support expansion and consumption. Hoover's administration raised the income tax and cut spending for a balanced budget.

A combined monetary and government bias to stimulating consumption while restoring balance and correcting the errors that fostered the credit bubble is the more effective course of action.

Today it seems to us that the Fed and Treasury are trying to cure our current problems by filling the banks full of liquidity with the idea that it will eventually trickle down to the real economy through their toll gates.

We believe this will not work. The financial system is rotten, and not only in its toxic and fraudulent assets. It is a weakened, rotten timber that will provide scant leverage for the rescue attempts.

Better to cauterize the bleeds in the financial system and assume a 'trickle up' approach by reaching the econmy through the individual rather than the individual through the banks.

Provide secure FDIC insurance to everyone to a generous degree , and let those banks who must fail, fail. You will encourage reform and savings, we guarantee it. Stimulate work and wages, and then consumption, and the financial system will follow.

While the financial system as it is constituted today remains the centerpiece of our economy, we cannot sustainably recover since it is a source of recurring infection.

Globalists like to cite the introduction of the Smoot-Hawley tariffs as a major factor in the development of the Great Depression. This appears to be largely unsubstantiated, and attributable to a dogmatic bias to international trade as a panacea for failing domestic demand.

In fact, before Smoot-Hawley both exports and imports were in a steep decline as consumption collapsed around the world. If the US had declared itself open for free trade, to whom would they sell, and who in the US would buy? Consumption was in a general collapse around the world. Smoot Hawley did not help, but it also did not hurt because it was largely irrelevant.

It is a lesser discussed topic, but the US held the majority of the gold in the world in 1930 as the aftermath of their position as an industrial power in World War I and the expansion that followed. Since the majority of the countries were on some version of the gold standard, one could make a case that the US had an undue influence on the 'reserve currency of the world' at that time, and its mistaken policies were transmitted via the gold standard to the rest of the world.

The nations that exited the Great Depression the soonest, those who recovered more quickly and experienced a shallower economic downturn, were those who stimulated domestic consumption via public works and industrial policies: Japan, Germany, Italy, Sweden.

As a final point, we like to show this chart to draw a very strong line under the fact that the liquidationist policy of the Hoover Administration caused most assets to suffer precipitous declines. Certainly some fared better than others, such as gold which was pegged, and silver which declined but not nearly as much as industrial metals and certainly financial instruments like stocks which declined 89% from peak to trough.

FDR devalued the dollar by 40%, but he never followed Britain off the gold standard, maintaining fictitious support by outlawing domestic ownership. As the government stepped away from its liquidationist approach the economy gradually recovered and the money supply reinflated, despite the carnage delivered to the US economy and the world, provoking the rise of militarism and statist regimes in many of the developed nations.

There is a fiction that the economy never really recovered, and FDR's policies failed and only a World War caused the recovery. In fact, if one cares to look at the situation more closely, the recession of 1937 was a result of the aggressive military buildup for war in the world, the diversion of capital and resources to non-productive goods and services, and of course the general reversal of the New Deal by the US Supreme Court and the Republican minority in Congress.

As an aside, it is interesting to read about the efforts of some US industrialists to foster a fascist solution here in the US, as their counterparts and some of them had done in Europe.

What finally put the world on the permanent road to recovery was the savings forced by the lack of consumer goods during World War II and the rebuilding of Europe and Asia, devastated by war, significantly aided by the policies of the Allied powers.

A Depression following a Crash caused by an asset bubble collapse is a terrible thing indeed. But it does not have to be a prolonged ordeal.

Governments can and do make policy errors that prolong the period of adjustment, most notably instituting an industrial policy that discourages domestic consumption and money supply growth in a desire to obtain foreign reserves through exports.

From what we have seen thus far, we believe that the Russian experience in the 1990's is going to be closer to what lies ahead for the US. Unless the US adopts an export driven, low domestic consumption, high savings policy bias, non-productive military buildup and public works, and discourages population growth we don't believe the Japanese experience will be repeated.

Preventing the banking system from collapsing is a worthy objective. Perpetuating the symptom of fraud and abuse and 'overreach' that was becoming pervasive in the system before the collapse is not sustainable, instead leading to more frequent and larger collapses.

Balance will be restored, and a reversion to the means will occur, one way or the other. It would be most practical to accomplish this in a peaceful, sustainable manner, with justice and toleration.