Depression Avoided? Not Anymore

[After Clouseau accidentally reduces a piano to a pile of rubble]
Mrs. Leverlilly: “You've ruined that piano.. But that's a priceless Steinway!”
Clouseau: “Not anymore!”
- From "The Pink Panther Strikes Again‟ (screenplay by Blake Edwards and Frank Waldman)

“It is now clear,” wrote the late Hyman Minsky in Stabilizing an Unstable Economy (1986, Yale University Press) in his preface to the book:

that output, employment, and prices in advanced capitalist economies with complicated and evolving financial structures are liable to fluctuate. It is also clear that the instability natural to our type of economy has been stabilized since World War II. In particular, even though there have been enormous stresses and strains in the economic and financial system, a collapse of asset values, an uncontrolled epidemic of bankruptcies, and a deep and long-lasting depression have been avoided.

Well, not any more. The latest development in the rolling financial crisis was last week's shock deterioration in the health of UK life insurers, with shares in the UK's biggest insurer, Aviva, falling by a third after the company announced a pre-tax loss of over £11 billion. Legal & General shares fell by 29% and those of Prudential by a fifth. Is there any part of the financial services sector that is still uninfected?

Probably not. Something called "Global Finance‟ magazine recently issued its “World's 50 Safest Banks” list. Their approach: compare the long-term credit ratings and total assets of the 500 largest banks in the world. The slight wrinkle in their methodology is that nobody trusts the ratings agencies that brought us AAA-rated subprime derivatives, and nobody trusts the banks' opinions of what their assets are worth, least of all the banks themselves. Other than that, it's a flawless approach. (For what it's worth, HSBC (HBC) and the Nationwide Building Society are the UK's highest ranking banks, although the latter isn't in fact a bank, and they come in at a somewhat gloomy 19th and 42nd place respectively. That Nationwide makes it onto this list in the first place suggests that mutualisation – you might even call it "partnership‟ – has huge relevance for the containment of financial risk and the mature alignment of depositor / investor interests.)

Meanwhile, the crisis allows western governments to impose the sort of economic martial law that would be impossible via the ballot box. And so the (in a quaint legal fiction, nominally still independent) Bank of England takes a leaf out of Japan's book and tries its hand at so-called quantitative easing, also known as money creation. The trillion Pound question: will it work?

My name is Mervyn. What ‘ave you just givern me?

Economist Murray Rothbard ("America's Great Depression‟, Ludwig von Mises Institute 2000) made extensive analysis of why the inflationary policies of the US Federal Reserve failed during the Great Depression. Those policies proved to be counterproductive:

American citizens lost confidence in the banks and demanded cash... for their deposits... while foreigners lost confidence in the dollar and demanded gold... The more that... the Fed tried to inflate, the more worried the... public became about the dollar, the more gold flowed out of the banks, and the more deposits were redeemed for cash... The Fed purchase of government securities was a purely artificial attempt to dope the inflation horse...

You can give a banker money but you cannot make him lend. In 1932, US banks preferred to accumulate excess reserves rather than do their job. It might be easier, since the government has now become not just the lender of last resort but the investor as well, to mail us all cheques, or by-pass the banks altogether and just drop money out of helicopters as Bernanke originally suggested.

As Michael Pollaro wrote back in 2005 (“Waiting for deflation? I wouldn't hold my breath”),

Much to the chagrin of the Fed founders, an inflation-bent central bank alone was not enough to keep the banking system afloat, to ward off the bank run, to keep banks lending and deflation at bay. Perhaps the monetary framework needed some adjustments. Perhaps a few more obstacles needed to be removed to ensure perpetual inflation. And by 1933, at the Depression bottom, did government and big banking ever know it. What did they learn?

Lots and lots of scared depositors mean lots and lots of bank runs. Can't have that, so how about deposit insurance. And this pesky gold standard is a real problem. Not only does it limit the banking system's ability to print money and create deposits, but how are we going to provide for all this deposit insurance in a crunch if we can't print money? Maybe we should confiscate the people's gold and take the US off the gold standard.

From 1933 to 1935, Congress passed a series of acts – creating federal deposit insurance, eliminating the gold standard (domestically), further cartellizing the banks and centralizing the Fed's power base solidly in Washington – all aimed at enhancing the banking system‟s ability to inflate, unchecked.

Now here's a legitimate question for inflationists. Will this be enough to ward off deflation and put an inflation bias in the system, indefinitely? Well, if you add in the fall of Bretton Woods in 1971, completely severing gold from the dollar, the passage of the Monetary Control Act of 1980, bringing all depositary institutions under the Federal Reserve System and giving the Fed the ability to monetize any asset, and a populace that looks to government politicians to solve all their economic problems, I'd have to say yes.

Mervyn King also seems to think so. Witness his following remark to reporters in August 2007:

Zimbabwe has determined very clearly that if you want a higher inflation rate, you could have it.

Long-dated Gilts warmly welcomed the news of quantitative easing. As well they might, in the short term. For anyone that missed the December 2008 sharp spike in long Gilt prices, this feels like an excellent opportunity to get out.

Comments

[Uppai Mappla]

er... pianos cannot be reduced to rubble! "firewood" or similar would have been better.

2009 Mar 09 11:46 AM

[Mad Hedge Fund Trader]

You may be right. The markets continue to behave like a spoiled child throwing a tantrum because the global response to date has been too little, too late. China did the right thing with a stimulus package amounting to 16% of GDP over two years. But the US has so far come up with a package worth 6% of GDP over three years, which is clearly not enough. $881 billion sounds like a lot of money, but in this world it is only the down payment. Treasury Secretary Hank Poulson promised to ring fence toxic assets but never delivered, buying into the banks instead. Policy makers are not equipped to deal with the globally synchronized nature of this melt down. In 1988 world trade accounted for only 5% of GDP. Last year it was 33%, but is going to hell in a hand basket with stunning speed. More global coordination is necessary, no matter how distasteful that may be.

2009 Mar 09 12:53 PM

[Marcap]

Good comparison! In the movies however, despite all the "bumbling", they do manage somehow to accomplish their goals. I wish I had at least the same level of confidence in our political systems. Or is that being just a little too hopeful?

On Mar 09 12:38 PM ED K wrote:

> Inspector Clouseau pales in comparison to the inept bumblings running
> our government now!!!!!
>
> Good points made to support your lead line.
>

2009 Mar 09 07:29 PM

[untiringeagle]

Great sense of humor. These will be the kinds of jokes we'll tell each other while sitting around the campfire down by the railroad tracks and waiting for the beans to boil for supper. LOL

2009 Mar 10 05:12 AM

[Chris of NH]

This may be a rosy scenario...


On Mar 10 05:12 AM untiringeagle wrote:

> Great sense of humor. These will be the kinds of jokes we'll tell
> each other while sitting around the campfire down by the railroad
> tracks and waiting for the beans to boil for supper. LOL

2009 Mar 10 08:35 AM

[kelm]

In 1913 one of the top bankers in England made a speech in which he stated unequivocally that a general war in Europe was not possible as their economies were too interlinked. In August 1914 Europe began the process of systematically annihilating a generation.

Any official who says something cannot happen in this environment is most likely in error. It may not happen, but if their argument and world view is based on it never happening - look out. A US dollar crisis fits this bill.

2009 Mar 10 11:18 AM

[Chris of NH]

Anything a US official says now about the economy can be counted on to be a baldfaced lie. We all know this is true.


On Mar 10 11:18 AM kelm wrote:

> In 1913 one of the top bankers in England made a speech in which
> he stated unequivocally that a general war in Europe was not possible
> as their economies were too interlinked. In August 1914 Europe began
> the process of systematically annihilating a generation.
>
> Any official who says something cannot happen in this environment
> is most likely in error. It may not happen, but if their argument
> and world view is based on it never happening - look out. A US dollar
> crisis fits this bill.
>

2009 Mar 10 12:25 PM