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Sunday, September 22, 2019

Depression Economics, Part 1

Capitalism is the best economic system we have, but it is not perfect. When it fails, what do we do?

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Contrary to popular libertarian belief, the capitalist economy is not infallible. It is without competition the best economic system we have, simply because it is built around the idea that progress and success are the predominant outcomes of human nature. There has never been, and never will be, an economic system that can unleash man's talents and capabilities like capitalism can.

However, just like humans, the systems humans build are limited by our own imperfection. No, I am not talking about environmental pollution; there is a system built into the free market called "externalities" that, when allowed to operate properly without government tampering, allows us to deal with environmental degradation.

Nor am I talking about "inequality". The fact that some are wealthy and others are not is simply an expression of differences in human nature. That is not a moral reflection on the poor; I myself come from hundreds of years of abject poverty, and I am very proud of my hard-working forefathers. The point here is that one man's wealth is not another man's poverty. Capitalism offers opportunities for every poor person like no other economic system does.

No, the problem with capitalism is essentially a magnification of a character trait in the human psyche, namely the sound but imperfect aversion to risk. It is not that we are unwilling to take risks - we are indeed willing to do so, but when we do, we take a leap of faith based on risk calculations. 

We do not leap into uncertainty. 

Let's say you are walking through a tunnel, and there is very little light. You come across a hole in the floor that you cannot get around. You have to jump over it to continue. You are unable to see how big the hole is, or assess whether or not you can climb down and walk across its floor. You simply do not know its width or depth.

Do you make a leap of faith? 

Of course not. You try to change the conditions under which you would make the leap. You try to gather more information, simply. If there is no way to do so right now, you wait until you can find a way to gather more information. 

The economy works the same way. There are circumstances when the absolute majority of all entrepreneurs, households and investors find the conditions of economic decision-making to be too uncertain to commit any economic resources. When this happens, just like with the hole in the tunnel, it is better to hesitate and save yourself to make a decision another day.

Perhaps the most notorious example of this state of economic affairs is the Great Depression, but the Great Recession is also relevant. The latter was aptly named with reference to the former because there were similarities in how economic activity virtually collapsed in a short period of time. 

In both instances, the financial system has been blamed for causing the crashes; in both instances, government poured salt in an open wound with misguided economic policies. 

The problem is that the private sector does not always have the answer, either, even though many libertarians would like to believe it does. One example is Lawrence Reed, president of the Foundation for Economic Education. Back in August he wrote a piece commemorating the 90th anniversary of the start of the Great Depression:
Ninety years ago this very month—August 1929—most stock investors thought they’d never had it so good. By November, they thought they’d never had it so bad. They were pretty much right on both occasions, though things would get a lot worse before they got better. Amid today’s gyrating stock market and increasing talk of recession, let’s refresh ourselves on the momentous events of nine decades past.
Reed then focuses on government policies in an effort to explain how the depression came about:
Sparked by tax cuts from the Harding and Coolidge administrations (a good thing) and the Fed’s low-interest rates/easy money policy (a bad thing), the curtain was about to come down on the Roaring ‘20s by August 1929. The Fed reversed itself months before and had been jacking up rates. 
I do agree with Reed on the monetary policy side - I have warned repeatedly against both the European Central Bank and the Federal Reserve maintaining or going into negative-rate territory - but low rates themselves do not cause a recession. To do so, those rates would have to change our ability to calculate risk in investments. The Austrian-economics explanation that interest rates, kept low by the central bank, cause an over-commitment of capital for the future is almost impossible to prove. To do so we would need a parallel interest rate set by the free market under circumstances where the supply of credit is completely independent of the central bank.

The one point where the Austrian argument is correct, is that the lowering of the cost of credit makes more investments affordable, but that happens at any given level of risk. If an entrepreneur believes that he can afford it is worth building a new manufacturing plant if interest rates are three percent instead of six, then if the central bank pushes rates down from six percent to three he will make that investment. If the central bank were to keep the rate at six percent, he would abstain.

Understood this way, the Austrian criticism of expansionary monetary policy makes sense. However, then Reed's comment should focus not on the previously low interest rates, but on the increase prior to the beginning of the stock market meltdown. 

There is another aspect to irresponsible monetary policy that we will get back to in a moment. First, let's listen to Reed again:
The smartest investors were beginning to bail, sensing that a 180-degree shift in monetary policy might be the same as pricking an overblown balloon. The Dow Jones Industrial Average reached a high of 381.17 on September 3, 1929. It bounced up and down for the next six weeks but generally drifted lower. In what Time magazine’s Jennifer Latson labeled “The Worst Stock Tip in History,” famed economist Irving Fisher pronounced that “Stock prices have reached what looks like a permanently high plateau.”
In other words, if the Federal Reserve had kept interest rates low, would that have avoided the crisis? Could they have eased rates upward and caused a smooth deflation, right-sizing, of the stock market?

To answer these questions, we would first have to look at whether or not the Federal Reserve had really kept interest rates low enough to actually distort capital formation. Again, it is difficult but not impossible to prove whether or not this is the case. 

We would also have to look more closely at the macroeconomic circumstances at the time. We had seen a decade of strong economic growth; by conventional wisdom, the economy was ripe for a recession. I do not believe in that conventional wisdom, with one exception: there are situations where things are "as good as they can get". These are conditions when profit opportunities have been exploited to a point where further commitment of resources come with excessive risk, when - metaphorically - the macroeconomic price-earning ratio is so high that enough people begin to wonder if it is "worth the risk".

These circumstances apply not just to the stock market, but to the economy as a whole. When we have built good credit over a number of years, when we have bought a house and a car or two, and gotten a couple of credit cards; is it worth the risk to buy a time share, move to a bigger house or trade in one car for a more expensive one?

When a business is operating at high profits, with strong market presence and a good set of products; when it is facing increased costs on the margin to expand into new market segments or to develop and market new products; eventually it reaches a point where the cost of growing is too high to motivate the commitment of resources.

Things are "as good as they can get" for now.

It is at this point that an economy reaches its peak. This is where we become more prone to negative sentiments. This is where negative information, which under less favorable circumstances would be weighed against remaining market opportunities, can become decisive enough to cause investors, entrepreneurs and even households to pull back a bit.

A momentum is created for an economic contraction. It does not have to be a depression - it can just turn into a recession.

Before we explore this further, let us get back to Lawrence Reed:
the last week of October brought “Black Thursday” and one massive sell-off after another, as ordinary investors joined the plunge. The Dow cratered at a mere 41 in July 1932, representing about 11 percent of the market value of less than three years before. The 1929 high would not be surpassed for a quarter-century.
If we disregard the point about the long-term effects on the stock market, the rush-to-sell episode is a concentrate of the effects of a negative momentum. However, without references to underlying macroeconomic trends in consumer spending, capital formation and even taxes and government outlays, this event is made out to be just that: a speculative bubble.

Critics of capitalism use it to criticize capitalism itself. However, the stock market is only a reflection of the rest of the economy. If the shift in monetary policy, from keeping interest rates low to raising them, caused enough corporate investments to become unprofitable, then there were a direct tie from the Federal Reserve making a clumsy reversal to business activities and, eventually, the labor market. If not, however, there would have been no underlying reason for the stock market to crash. 

Sound-minded portfolio managers would have seen this, caught the market and made it rebound. 

More than likely, the Federal Reserve's actions coincided with an emerging "as good as it can get" sentiment in the economy as a whole. It is also entirely possible - even likely - that their low-rate policies had, on the margin, infused more cash into the stock market than would otherwise have been the case. The price-earning calculations for too many stocks would have been too inflated to merit speculative gains. 

However, again: speculation only inflates a market momentum. It does not create it. If speculation inflates a resilient market, and resiliency remains, then the deflation of the speculative bubble becomes an aberration, not the dominant story of the market.

If resiliency is gone, the bubble has nowhere to deflate to.  

The same point applies to the real sector of the economy. Suppose a car manufacturer invests in a new model in a new market segment where there is comparatively little experience to draw on. This is by definition a speculative investment, as it requires a higher-than-normal commitment of resources. If the rest of the manufacturer's product portfolio is doing well, the losses they take on the new-segment model will be absorbed and only cause minor reverberations in the business as a whole.

If, on the other hand, their margins on most other models are shrinking when the new model fails, it may have major repercussions into the very core of the business itself.

Normally, the collective mindset that creates a momentum for an economic contraction only results in a recession. On rare occasions the plunge from "as good as it can get" to "as bad as it can get" will be steep, fast and vicious. When that happens, we are hurled into a depression. 

In economic theory, the difference between a recession and a depression is that in the former, there are enough savvy investors and entrepreneurs who are willing to find new ways to make money. They can, simply, make risk calculations that are favorable enough to warrant a leap of faith.

Under exceptional but not impossible circumstances, uncertainty overwhelms the absolute majority of investors, entrepreneurs and households. We decide that it is time to save ourselves, so we can make a decision another day instead. 

Herein lies the real cause of the Great Depression. The stock market would not have crashed had not the underlying economy removed the rug from underneath it.

Reed overlooks this point. He is also incorrect in that government policies caused the depression. However, he does make a good point in that fiscal, monetary and regulatory policies prolonged and aggravated the depression:
The history of the Great Crash and subsequent Depression provides a sad litany of policy blunders in Washington. Altogether, they needlessly caused and prolonged the pain; roller coaster monetary policy, sky-high tariff hikes, massive tax increases, government-supervised destruction of foodstuffs, gold seizures, price-fixing regulations, soaring deficits and debt, special favors to organized labor that stifled investment and boosted unemployment.
If anything, government poking around in the economy aggravated the uncertainty that had already set in and come to dominate the mindset of economic decision makers. At the time, there was an emerging school in economics that subsequently led to Keynes writing his seminal General Theory. It said that government does have an active role to play in the economy, and that there are circumstances when government can be the only mover to re-establish confidence in the future of the economy.

At the time the Great Depression broke out, the thinking along what has since become known as Keynesian economics were only in their crude stages, prone to be misunderstood and overshadowed by radical, anti-capitalist thinking originating in Marxism. Keynesianism, as per Keynes's own hand and subsequent contributions from Hansen, Hicks, Davidson, Okun and even Shackle,  were absolutely not Marxist in nature. Not at all.

It is understandable, though not excusable, that some politicians tried to put this emerging line of thought to work. They were playing with fire and the country would have been far better off if they had abstained entirely from experimenting. It was not until General Theory had been published and its subsequent debate had extracted its highlights in policy terms, that we could better understand the proper, and very limited role of government.

There is, namely, a role for government to play beyond its minimal-state functions. It is exceptional and temporary and confined exclusively to the macroeconomic conditions that cause and establish a depression.

It is also a role that is dangerous to play, simply because it easily gets hi-jacked by ideologues. 

More on that in Part 2. Stay tuned.

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