Whistling Past the Depression

Ben Bernanke – for it was he, of course – has found himself in an even more privileged position to learn such lessons. As chairman of the Fed, his record already deserves more plaudits than those prematurely heaped upon his predecessor. How lucky for us that a Great Depression buff was running the Fed when a second Great Crash came along! For this time the contractionary forces have not been intensified, in the name of sound money. Instead, an active monetary policy has pursued a strategy of easing credit restraints on the real economy, and the threat of inflation has been rightly dismissed as a purely notional danger under present circumstances. FT

The Fed, according to a scan of the financial news, is currently debating the timing and method of an "exit strategy" from the zero-interest-rate-policy (ZIRP), which, according to the above view, saved the US from a repeat of the Depression. This may well prove to be true, and if so, would be, in my view, an example of the myopia inducing effects of unproved assumptions.

The assumption, in this case, is the belief that a good deal of the pain of the Great Depression could have been avoided by policies enacted after the Crash of '29.

This was Milton Freidman's assumption and, judging by Mr. Bernanke's academic work and recent speeches, his as well. Depressions, they think, can be "cured". Most people have not studied the Great Depression but in many cases seem more than willing to whistle past the the idea of a Depression- uneasily perhaps, but unwilling to change course while, knowingly or not, willing to put their faith in conclusions similar to those in the opening paragraph.

Conclusions drawn from a study of any historic event will necessarily be colored by prejudice. Open minded people, without an axe to grind, might quickly lose those prejudices that seem inconsistent with the facts and theoretical bent, if any, while the less open minded, for whatever reason, will come away with their main prejudices confirmed.

Perhaps because I've studied the Depression without hopes of being an economist with a future at the Fed or of writing any policy-effecting book on the topic (I'm lucky to get 1000 page views on this site) but rather as a husband and father who merely wishes to muddle through without calamity, my read of that (and the preceding) period in US history is that there is no "cure". Perhaps in the event that Plato's Philosopher-Kings ran the world, Depressions might be avoided- although this would involve a system of political economy very different from ours- but never cured.

The reasoning behind this view is as follows. Depressions, in contrast to the more common financial or inventory overheated recessions, are caused by many years of what Austrian Economists call mal-investment- investment, and by consequence, education and employment patterns predicated on a view of the future radically inconsistent with the economic conditions that actually unfold.

Depressions are not, in my view, caused by the financial crises that tend to precede them. Rather the financial crisis is the moment when the mal-investment is first revealed to the unsuspecting, usually without changing too many minds.

In the case of the Great Depression of the 30s, the view upon which mal-investments were based was that there would always be willing and able consumers to buy whatever the US manufacturing machine was capable of producing at a profit to their costs. In the event, US manufacturers discovered they had grossly over-estimated the willingness and ability of the world's consumers to buy their goods. Had the emergence of World War II not provided insatiable consumers, and provided a crisis-induced mental reboot of the population, if you will, I suspect the 40s would have been far grimmer in economic terms than it proved to be.

In our current situation, the mal-investment is, in a sense, reversed. Instead of believing that consumers are infinitely willing and capable of buying their goods, the US believes that suppliers are infinitely willing to accept US$s in exchange for goods, regardless of US official policy towards their currency. Instead of people trained to work in factories, and an infrastructure geared to manufacturing, people are trained to work in Dilbert style cubicles, and our infrastructure is geared for an endless supply of cheap oil.

In both cases, strong lobbies resist change. Manufacturers had their thumb on government for much of the 20th Century, only to find their position usurped by Finance, which it still retains. Long standing beliefs as to the virtues of such influence will be slow to change, as will the beliefs of many people who, in my view, are educating and training themselves for a world that won't manifest.

World War II, as earlier noted, provided a crisis that engendered a period when one could look at the world with fresh eyes. In the US families of farmers and laborers were able to dream of sending their children to college to become engineers, scientists, doctors and lawyers, or even to do this themselves.

I don't yet see such a catalysts for a mental reboot in the present period, although perhaps a US$ currency crisis might prove sufficient (and hopefully a war won't be necessary).

The thrust of my view is, to the extent I've correctly identified some of the causes of the Depression, the required mental changes in a good deal of the population, not to mention the manifestations thereof in education, training and investment will take years to unfold. If the US will no longer be able to set the terms of trade more or less unilaterally, we have a long way yet before our economy is ready to compete. At a minimum the US population must accept that they will have to produce much more to enjoy the same standard of living, or deal with less.

In 2007, Fed Chairman Bernanke argued:

Economic growth and prosperity are created primarily by what economists call "real" factors--the productivity of the workforce, the quantity and quality of the capital stock, the availability of land and natural resources, the state of technical knowledge, and the creativity and skills of entrepreneurs and managers. He then went on to highlight the crucial supporting role that financial factors play in the economy.

I think he continues to place too much emphasis on the latter and not enough on the former in his views and the policies which emerge therefrom (on second thought he hasn't done a great job in getting finance to help the real sector either- leveraged bets on bond market capital appreciation doesn't seem like a cure for anything).

He, and many others may think they can whistle past a Depression as easily as they whistle past a graveyard, but in the case of a Depression, the Bogeyman is real.

Comments

[Mad Hedge F...:]

xhi First of all, let me warn you that reading this paragraph is a complete waste of your time. Still interested? There is chatter about that the Fed is considering a surprise interest rate rise at its upcoming meeting. After all, where can they go from zero, but up? They could be emboldened by the recession ending Q3 GDP of 3.5%. The bond market is certainly telling us that rates should go higher, with yields on ten year Treasuries jumping from 2.45% to 3.40% since March. Unfortunately, this is the usual kind of gibberish you get from pundits and prognosticators , who, at a loss for any explanation of the real reasons for Friday’s melt down, resort to making stuff up out of thin air. US industrial capacity utilization is terrible, while unemployment is rising to record levels. Banks still aren’t lending to small businesses, the largest job creators in the country, because they are about to get hit with an onslaught of bad commercial real estate loans. Sure, commodity prices have doubled or tripled this year. But this happened because investors were desperate for any alternative to the sickly dollar, not because there is huge underlying demand by end users. This is one of the reasons why I have been ringing the alarm bell about all long positions for the last three weeks. So I can say with complete confidence that the chances of an interest rate hike are less than zero for the foreseeable future. This discussion did have the one benefit that it did enable me to fill this space in my newsletter.

Nov 04 07:07 AM

[Old Trader:]

"Economic growth and prosperity are created primarily by what economists call "real" factors--the productivity of the workforce, the quantity and quality of the capital stock, the availability of land and natural resources, the state of technical knowledge, and the creativity and skills of entrepreneurs and managers"

Its become increasingly common to pay lip service to ideals like this, while working fervently to undermine them.

Nov 04 09:19 AM

[phil from E...:]

What the government and the Fed have accomplished compared to the great depression is minimizing some discomfort to the individual. For example, we aren't standing in line to remove our deposits from insolvent banks. Safety nets for the unemployed and the foreclosed are still limiting the visibility of the damage.

The Fed has tried some novel steps. The FDIC and the GSE's have bankrupted themselves. But like you imply, we aren't really addressing the problems. I'm not even sure we agree on what the underlying problems are that need to be solved. Meanwhile the Treasury borrows unimaginable amounts of money. The bogeyman is real.

Nov 04 09:41 AM

[ryanclarke:]

The article's author wrote ," I think he continues to place too much emphasis on the latter and not enough on the former in his views." Well said. My feelings exactly. I'll even go further. Bernake only gives a damn about the banks ... as that is who he works for ... the banking institutions which have their mommy ... what we call the Central Bank ... to run to everytime something doesn't go their way. Originally, the Fed was put in place to only deal with inflation ... the Central Bank was to "fight" the natural tendencies of small private banks to "inflate" via overactive lending ... by raising short term interest rates to subdue inflation before prices got out of hand. NOT ANYMORE !

Nov 04 12:24 PM

[Steve Pasq:]

Great article. Everyone wants the "system" to work because the alternative is hard to swallow. The stink comes when the "crucial role" of financiers is to rewrite loans and rake off outrageous fees and commissions in the process. It doesn't seem very productive to me but maybe I'm just in the wrong business.

Nov 04 12:42 PM

[Tom E.:]

The productivity improvements have taken place in the US and the new investment has gone to Asia.

As a result, we are left with a labor surplus and no new industry to absorb the displaced workers.

Nov 04 12:54 PM

[bob adamson:]

A good summary, Mr. Lewis, of the conventional Austrian School assessment which, at least as it relates to the prescription to address the sort of crisis that crested in October of 2008 in the short term, is fundamentally at odds with both a broad cross section Keynesians and Monetarists like Milton Freidman.

Arguably the question is not whether a deflationary recession could have been avoided by stimulus measures such as those begun in earnest in the second half of 2008 but rather whether such stimulus:
1. could ameliorate the impending potential impact on both individuals and economic structures and institutions (i.e. make the recession shallower and shorter in duration) in a way that prevents the wasteful chaos and destruction of a full blown deflationary depression, and
2. would provide a bridge to allow a more orderly reconstruction of the economy?

In answer, as of September of 2008 there was no pain free or easy answer to the accumulation of economic problems to be faced. The alternative to stimulus (simply letting the free market respond as it would without intervention) would clearly and very rapidly have plunged the world into a deep depression. On balance, the course of stimulation that was, in fact, followed at least offers the prospect of an orderly recovery; a prospect that will be squandered if fundamental reforms are not devised and implemented. The real task now, therefore, is to map out the reform of economic structures and institutions that must take place during the window of artificial stabilization and incipient recovery engendered by the stimulus measures.

Nov 04 05:02 PM

[shankfisher:]

This is just like in Cormac McCarthy's The Road: you know the situation before you is impossibly complex, the odds insurmountable, and yet you keep doing what makes you feel good. It is important to believe in your own capabilities, to feel like you can handle the problems -- but really, seriously, the boy was saved by chance, not by the father's actions, no matter how much he loved the boy. The economy is much the same; chance matters most. Everything else is too complex. The Greatest Depression is coming, and you better sink your assets into that which will sustain you and yours.

Nov 05 12:31 AM

[Gregman2:]

In the Phillipines there's a saying, "At a distance none that appear well smell bad." From a distance, we see few details. Fish, women, currencies...soon all will be for sale at a discount.

Nov 05 04:53 AM