How Central Banks Destabilized the World's Economies

The crisis that America finds itself in is not political in origin nor can it be laid at the feet of any individual or party. The whole world, including Europe, is experiencing a massive monetary disruption. Moreover, it is not the first time that the world has been shaken by a financial crisis. It happened in 1824 and it happened again after WWI. What is depressing is that though these crises have but one single cause, today' s central bankers and legions of economists find themselves utterly clueless, readily taking as a causes those data which are in fact symptoms of a very deep monetary disorder.

Monetary disorders are always the product of inflationary policies

Two economic fallacies govern the actions of central banks. The first one is that of the stable price level. According to this fallacy so long as prices remain stable the economy cannot fall into a recession. This fallacy was championed by Irving Fisher. It cost him $10 million. Those who argue that the money supply should be manipulated in away that prevents prices from either rising or falling have assumed that though individual prices are determined by supply and demand the level of prices is a function of the money supply.

This view cannot withstand even a cursory examination. Money always enters the economy at certain points from which the effects of these new spending streams ripple outwards. Even if a " helicopter" approach is assumed in which everyone simultaneously receives the same amount of money, the theory still breaks down because people' s preferences are neither identical nor fixed. Not every economist at the time agreed with Fisher, as the following quote shows:

...difficulties are viewed largely as the inevitable aftermath of the world' s greatest experiment with a " managed currency" within the gold standard, and, incidentally, should provide interesting material for consideration by those advocates of a managed currency which lacks the saving checks of a gold standard to bring to light excesses of zeal and errors of judgment. (C. A. Phillips, T. F. McManus and R. W. Nelson, Banking and the Business Cycle, Macmillan and Company 1937, p. 56).

If Fisher and his disciples had been correct, he would not have lost his fortune and much of his reputation as an economist. During the 1920s, the Fed almost doubled the money supply. So why didn' t this raise prices? It did. Commodities boomed as did the demand for capital goods. Because of the focus on consumer goods the prices of capital goods and land were ignored. What makes this observation of critical importance is that it blows away the theory that prices can be stabilised. They cannot.

Changes in money streams will always change the price structure and hence the pattern of production. (Richard Cantillon, Essay on the Nature of Commerce in General, Transaction Publishers, 2001, written about 1734 and first published in 1752). These money streams are brought into existence by the central banks forcing down the rate of interest below its market rate. Consequently businesses take on more time-consuming projects, projects that are economically justifiable because the necessary capital is not available to complete them. What central banks are in effect doing is substituting credit for capital. In the mid-'20s it was observed that the

tendency to substitute bank credit for real capital [capital goods] was looked upon as a very ominous tendency. The years 1924-29....abundantly justified these apprehensions. (Benjamin M. Anderson, Economics and the Public Welfare: A Financial and Economic History of the United States 1914-1946, LibertyPress, 1979, p. 99).

The second fallacy is that recessions are caused by "deficient demand". This is probably the most dangerous economic fallacy around. Its adoption by the mass of economists and hence central banks is a curse for which we can thank Lord Keynes. This invites a simple question: Why is it that more and more monetary injections are needed to prevent recession?

The classical economists had the answer and it was called disproportionality. They noted two things: The first being that the "revulsion" as they called always started with manufacturing. The second thing being that these disruptions always occurred in clusters. Ricardo arrived, and rightly so, at the conclusion that the problem was caused by the banking system creating excess credit. (Excess being defined as bank deposits exceeding the banks' gold reserves). It is this excess credit is what fuels stock market booms. Fritz Machlup explained that a share market boom requires a continuous flow of bank credit. This can only happen if the central bank loosens the monetary spigot. Therefore a

... continual rise of stock prices cannot be explained by improved conditions of production or by increased voluntary savings, but only by an inflationary credit supply. (Fritz Machlup, The Stock Market, Credit and Capital Formation, William Hodge and Company Limited, 1940, p. 290).

Today's economists miss what became self-evident to the early economists: Ultimately "products are always bought with other products" . (Jean-Baptiste Say, A Treatise on Political Economy, 1836 edition republished by Transaction Publishers, 2001, p. 166. Also chapter XV). Say and the classical economists fully understood that goods had to be produced in their proper proportions, i.e., equilibrium had to prevail. Say's response to the charge of over production was to point out

... that the glut of a particular commodity arises from its having outrun the total demand for it in one or two ways; either because it has been produced in excessive abundance, or because the production of other commodities has fallen short. (Ibid. p. 135).

David Ricardo was at one with Say on the issue of gluts:

Productions are always bought by productions, or by services; money is only the medium by which the exchange is effected. Too much of a particular commodity may be produced, of which there may be such a glut in the market, as not to repay the capital expended on it; but this cannot be the case with respect to all commodities; the demand for corn is limited by the mouths which are to eat it, for shoes and coats by the persons who are to wear them; but though a community, or a part of a community, may have as much corn, and as many hats and shoes, as it is able or may wish to consume, the same cannot be said of every commodity produced by nature or by art. (On The Principles of Political Economy and Taxation, Penguin Bookes, 1971, p. 292).

Concerning the problem of booms, busts and so-called general gluts, an exasperated Ricardo wrote to a friend that

Mr. Malthus never appears to remember that to save is to spend, as surely, as what he exclusively calls spending. (The Works and Correspondence of David Ricardo Vol. II, liberty fund Indianapolis 2004, First published by Cambridge University Press in 1951 p. 449).

In 1829 or thereabouts John Stuart Mill wrote a devastating critique of the idea that aggregate demand can be deficient. Adhering to Say' s law he emphasized that so long as wants remain unsatisfied and the means to sate them are scarce then the notion of " general over-production" is absurd. The key to his argument is the insight that demand springs from production, not consumption. As he eloquently put it:

The argument against the possibility of general over-production is quite conclusive, so far as it applies to the doctrine that a country may accumulate capital too fast; that produce in general may, by increasing faster than the demand for it, reduce all producers to distress. ... It is true that if all the wants of all the inhabitants of a country were fully satisfied, no further capital could find useful employment; but, in that case, none would be accumulated. So long as there remain any persons not possessed [of goods], … there is employment for capital; and if the commodities which these persons want are not produced and placed at their disposal, it can only be because capital does not exist, disposable for the purpose of employing, if not any other labourers, those very labourers themselves, in producing the articles for their own consumption. Nothing can be more chimerical than the fear that the accumulation of capital should produce poverty and not wealth, or that it will ever take place too fast for its own end. (Essays on Economics and Society, University of Toronto Press 1967, p. 278).

William Stanley Jevons, one of the first neo-classical economists, also explained why general gluts (demand deficiency) were not possible. In his opinion

Early writers on Economics were always in fear of a supposed glut, arising from the powers of production surpassing the needs of consumers, so that industry would be stopped, employment fail, and all but the rich would be starved by the superfluity of commodities. The doctrine is evidently absurd and self-contradictory .. Over-production is not possible in all branches of industry at once, but it is possible in some as compared with others. (The Theory of Political Economy, Kelley & Millman, Inc. 1957, p. 203, first published in 1871)

For Jevons and his contemporaries genuine purchasing power could only spring from production. It should be easy to see from this observation that as individuals increase their real purchasing power, i.e., expand individual output, total output rises, which is just a fancy way of saying that total demand has expanded. This process of exchange will tend to equate the value of the worker' s output with that of his wages. All said and done, we can now say at this point that purchasing power is another term for exchange power, which in turn is labour' s ability to create goods for exchange.

Yet something that would be glaringly obvious in a barter economy drops out of sight with the appearance of money. If the fundamental principles that the early economists discovered were resurrected and adhered these crises would not develop.

It clear that the crisis was not caused by political incompetence but by very bad economics. Unfortunately, this fact will not satisfy political bigoted journalists like Thomas Frank of the Wall Street Journal for whom lying is second nature. It is not much different in Australia, for which Rupert Murdoch much shoulder some of the blame. The idiotic Peter Jonson (aka Henry Thornton) had the audacity to blame President Bush and Cheney, pompously declaring that

Bush and Dick Cheney should resign just as soon as the votes are counted in the current election. The Speaker of the House, who would become acting President and would be expected to work closely with the President-elect on the plan to restore trust to the world' s financial system.

Other Prime Ministers and Presidents should look deeply into their souls and decide whether or not to resign — after appointing a person of proven experience who has no interest in the coming election to run the Government until the election is settled. (The Australian, It' s time to restore trust, 10 October 2008)

If anyone needs to do any soul searching, it's the sanctimonious Jonson and his mates. Their crummy economics brought about this crisis. Now the puffed-up ass wants to put the cretinous Pelosi in charge of the US economy. I am truly sick to death of political flakes like Jonson and their imperious announcements about Bush.

Comments

[Steven Hansen:]

gerard, tell me this is not econ-political bull$hit. i really liked this article until the end. bush, cheney, obama, mccain, pelosi, reid, et al are responsible, as well as the fed, the wall street snake oil salesman, and the bureaucrats.

2008 Oct 24 05:57 AM

[Errol:]

Wall street snake oilsalesman? The price of oil is created on an exchange, via buys and sellers.

2008 Oct 24 11:53 AM

[Old Turk:]

Very insightful article. I agree that the executive branch is the least to blame for the current mess (as long as we exclude Iraq from the definition of "mess"). The worst U.S. president was Wilson, who jammed the creation of the Federal Reserve past the judiciary (and then jammed the U.S. into WWI just as the Europeans were all tiring of the slaughter and were about to seek an armistice, thereby causing a lopsided defeat of the Huns, in turn causing excessive demands for reparations by Germany, in turn causing hyperinflation, followed by the inevitable Hitler). We did not need a Fed, we needed continuation of the gold standard and balanced budgets, and no war. Additional current culprits are Congress, which approved mindless increases in leverage for Fannie and Freddie, the SEC, which lifted constraints on leverage for investment banks around 2003-4, the insanely low fed rates during Greenspan's terminal tenure that caused misallocation of credit and bubbles, and all the greedy mortgage bankers, home appraisers, liars applying for mortgages, investment bank securitization of toxic waste, complete disregard of rational evaluation by all the rating agencies.... Please don't get me started! Bush may not smell like a rose, but in this economic fiasco he is quite far out on the periphery.

2008 Oct 24 12:36 PM

[swaps:]

I think I read that when Wilson died he said something like "I have unwittingly ruined my country."

Maybe 20 years ago the late Malcolm Forbes Jr. railed against the Federal Reserve, accurately pointing out that it alternately pushes on the gas too hard and then hits the breaks too hard. This does destabilize the economic process.

The Federal Reserve is not an inflation fighter but was created to inflate the money supply so that wages rise so borrowers can sort of keep up with interest payments. A stable wage rate and money supply would result in more and more money accruing to the lenders and the system breaks down.

There are 20 causes for the current mess - give or take 10 or 20 more - but one of the contributors is the offshoring of millions of well-paying jobs and importing cheap foreign labor. The resulting wage stagflation overall was the wall that the banking system hit.

Everyone in Congress has totally forgotten that in the waning days of the Greenspan era the Fed began jacking up rates from their abnormally low levels to "stop inflation" by deliberately slowing the economy and putting people out of work.

The rate jacking was continued by Bernanke - whose college summer job was with a sort of Khazar gangster by the way.

The Fed has accomplished its "inflation fighting" slowing of the economy = so what is all the fuss about? This is what the Fed set out to do, and the tax revenue and foreign borrowings insulated Washington beltway went along with it as they snorted and gorged at their own well supplied feed troughs.

The Fed should be abolished and limited to check clearing.

The Executive branch should be indicted for abolishing the uptick rule. Just a few hours ago yet another insightful money manager said on CNBC that was a mistake that should be corrected at once.

You could build a case the uptick rule was eliminated by forward thinkers who knew what was going to happen how the rule was keep the investment bankers from which Paulson is a derivative could make billions by short selling, the only way they have left to make money right. They can't m&a or borrow from money center banks to profit from commodity spikes fueled by the lent money created out of thin air. Their sub prime honey pot has turned bitter.

The Fed, the executive branch, the regulators, the rating agencies, Wall Street, the Democrats in Congress, the foreigners who shoveled in their money, Realtors, appraisers, illegal immigrant construction workers, the media, et al. are to blame.

But let's start with the Fed. And Paulson and the SEC.

D

2008 Oct 25 12:43 AM

[Erick Tippett:]

Mr. Jackson,

Though I feel your discourse on the underlying cause of economic problems (world wide as well as here in the United States) is a bit lengthy and perhaps difficult for the average person who really needs to understand its content, your point is well taken indeed. It is my honest opnion that the neurotic worship of Lord/Lady Kenyes' economic philosophy has a great to deal do with our present economic malaise!

The fact that you mention so many individuals (Richard Cantillon,
Benjamin Anderson, C. A. Phillips, T. F. McManus, R. W. Nelson, David
Riccardo, John Stuart Mill) some of whom lived long before Ludwig Von
Mises, one of the founders of the Austrian School of Economics, was
born, certainly must be given weight and consideration as accurate
arguments in the case for economic wealth based upon production and
saving as opposed to credit expansion unchecked!

We also had an economic crisis in 1907 as I recall in which J. P. Morgan
the banking tycoon 'rescued' the banking system with large inlays of
liquidity. This action was followed by a successful plan to bring the U.S.
back into the 'central banking fold' in l913 effectively killing the free mar-
ket system which strangely is blamed by some for the present economic
crisis!

As I've said the people (our American public) who should understand the
particulars of this economic system haven't a clue as to what all this is
about, and tragically so indeed. After all, our majority American Public
continually elect and re-elect the people that put in place the Green-
spans (once an associate of Ayn Rand a famous Austrian Economist),
Bernankes, Paulsons, and Coxs! I sat in disgust as the tally in congress
for passage of the 7Billion dollar bailout showed votes for Republicans,
votes for Democrats, and not one single vote for Independents! No
wonder Ron Paul comes off to the public as some kind of off-beat radical
with crazy ideas about economics and how the world should be! And of
course our brilliant and objective American Press and media have con-
tributed their unseemly and obnoxious influence to the mix.

Unfortunately the fate of this present world system, which could easily slip into a facist world government overnight, (The Swiss are now being and have been pressured by Germany and France into abdicating the
right to privacy of their foreign banking customers that they have extended to all Swiss bank clients for centuries) is in danger of collapse,
depending upon how far the powers that be are willing to go in order to preserve their virulent fiat currency systems (Luis T. Mcfadden U.S. House of Representatives Chairman-later member-of the Committee on banking and finance in the late 1920's was shot at twice on his way into a New York Hotel one day and poisoned in the dinning room there days after he had raged against the illegal acts of the Federal Reserve Board asking for its dissolution and calling for the impeachment of Herbert Hoover! Mr. McFadden was a Republican by the way, not a democrat!).

For those interested in the case of Representative Mcfadden's contro-
versial assertions, Google Search has excellent and accurate account
of the issues and people involved. Misses.org also has excellent
articles and tutorials on economic philosophy including Keynes.

EDT
Chicago, Illinois

2008 Oct 25 02:26 AM

[Steven Hansen:]

an oversimplification is that austrian economics tells you how to avoid recessions and keynsian economics tells you how to get out of one. a lot of people have been referenced in this article and comments made. you need to judge for yourself how relevant the knowledge of the economist being quoted is to the point the author is arguing:

Luis T. Mcfadden (died 1936)
- was anti-Semitic
- supporter of hitler
- said federal reserve caused great depression
- claimed wall street funded bolshevik revolution

john maynard keynes (died 1946)
- believes markets and employment will find their own equilibrium
- that it is possible to stimulate the economy through public works and lowering interest rates
- was a theorist, and did not really develop implementation platforms for his beliefs
- believed in redistribution of wealth through taxation
- he believed economic stimulus should be directed towards the lower-income segment of the population, because that segment is more likely to spend the money, contributing to demand, than to save it
- did not really have profound ideas about inflation.

Richard Cantillon (died 1734)
- provided some of the foundations for the Austrian School
- provided no real insights on currency, credit, inflation or depression
- laid foundation for the relationships of labor versus output
- mostly theorized about relationship between land, labour and agricultural output.

Benjamin Anderson (died 1949)
- was a follower of the Austrian School
- was a leading opponent of the New Deal and an enthusiastic supporter of a free market gold standard.

Ludwig von Mises (died 1973)
- one of the leaders of Austrian School
- any unsound credit expansion causes business cycles
- believes socialism will fail do to the impossibility of a socialist government being able to make the economic calculations required to organize a complex economy
- that without a market economy there would be no functional price system
- based his theories on the concept that man would act rationally, accumulate what made him happy, and avoid things which did not make him happy.


C.A. Phillips, T.F. McManus, and R.W. Nelson
- Austrian School wrote a book in 1937 "Banking and the Business Cycle"
- believed the reason for the great depression was the credit expansion of the 1920's causing suppression of wages and imbalancing the savings/consumption ratios.


David Ricardo (died 1823)
- argued free trade between countries
- he thought that how a government pays for its expenditures might effect the economy of that country.
- he believes profits decrease as wages increase

John Stuart Mill (died 1873)
- a free trader
- taxation is acceptable under certain criteria but argued strongly against a progressive tax structure

2008 Oct 26 11:43 PM