Archive for December, 2008

Financial Crises

I recently came across a reference to a 1972 book called Panics & Crashes and How You Can Make Money Out of Them, by Harry D. Schultz. I dug up a copy and it has even more bearing than I thought on our current situation.

First off, the book is soothing. We’ve been feeling rather apocalyptic about the economy, but this book puts the present financial crisis in perspective. Not that it isn’t bad, but most of the book details the history of such crises. Financial panics, it turns out, are a normal part of life, not the end of the world. If you doubt me, buy this book and read about the Panics of 1837, 1857, 1861, 1873, 1884, 1893, 1901, 1907, 1913, 1921, 1929, 1937, 1962…. Then there’s the recessions and depressions he discusses.

And guess what? They were pretty much all caused by the same thing: easy credit brought about by government interference:

Fundamentally, an upswing in the business cycle is brought about by an expansion of credit…. This credit expansion, matched by an expansion of money in circulation, also sustains the rise in business activity, as long as the former lasts. The key to such credit expansion lies with the banking system – banks ease borrowing conditions, lower rates, literally push money onto their clients, in order that they, the banks, can expand and make more money in the process.

The brake to the boom also inevitably coincides with that time when credit expansion stops. In fact, as [R.G.] Hawtrey [author of Good and Bad Trade, published in 1913] put it, “If the restriction of credit did not occur, the active phase of the trade cycle would be indefinitely prolonged, at the cost, no doubt, of an indefinite rise of prices and an abandonment of the gold standard.” This is, of course, exactly what happened to the United States in 1971.

Prior to 1929 government force-fed the economy for so many years after a normal reaction was due, that when the reaction did come (in spite of the government) only disaster could follow. And follow it did.

Also, because government did something in this century (1913) in the form of the Federal Reserve Act, it built into the system a means whereby the economy could continue to appear to prosper long after the setback should have occurred. This meant that the U.S. suffered far less from World War I than it should have. It also suffered less from the 1921 postwar depression than the rest of the world. But when the 1929 crisis hit, the entire country was plunged into total chaos and depression. The 1929 depression is probably the all-time classic example of the system whereby tomorrow is mortgaged in order to allow today’s prosperity to reach unprecedented levels.

Without the Federal Reserve Act it is true to say that things could not have soared apparently upward on such shaky wings until 1929. The end would have come in a short, sharp burst long before that happened.

But then when 1929 was all over, nobody learned. Nobody blamed the system for allowing too much credit. Government economists blamed the brokers and banks for exploiting the law of lax money.

We don’t have to do this:

Left to itself the business cycle would probably ebb and flow in small waves at relatively frequent intervals. No government can stop this from happening. All it can ever do is alter the timing. For example, government may stop us having a minor recession every couple of years, one which we would barely notice. Instead, we get the recession in one big glob every 20 years or so, and then we suffer for several years from it.

Why does government do this? To buy time. A politician’s first duty is to get elected. Thus when things look slightly bad the politician feels obligated, for self-survival, to cover up.

He mentions this normal failing of politicians again:

Politicians also find inflation a good thing. They can promise wage increases and subsidies. They can announce all sorts of public works projects, knowing full well that inflation will soon offset their grandiose figures.

To me, this passage was the most painful. I love my country and always will. In recent years I’ve had to re-evaluate many widespread American assumptions, including those shared by most conservative Americans. I’m reluctant to discuss my new doubts, lest I be mistaken for the tinfoil hatters who believe that there is no terrorist threat, that America is the root of all evil, and that socialism is going to suddenly start working if we just try it one more time. The passage below is the kind of information that’s forced me to rethink things:

After World War II, unlike Europe, America was not plunged into a postwar depression. The main reason for this was her loan policy to war-torn Europe (that is, loaning or giving money to those who would buy U.S. goods with it), and because U.S. inflationary wartime policies were continued, and because labor managed to negotiate wages to keep up with the inflation rate. So the whole complex was able to coast for a number of years. Then of course the Korean War added impetus to the economy, and it was only when this was all over and defense production fell that the U.S. belatedly had its recession.

Lest anyone get the idea that such unsound policies can keep a nation truly prosperous, it should be made part of the record that this postponement of problems was made possible by the following circumstances: The U.S. sold war goods to its allies during two world wars and as a result skimmed off most of their gold (the only true measure of wealth). The U.S. then proceeded to spend that gold over two decades like a profligate nephew of a rich uncle who died.

I’ll leave you with this graph scanned from the book. If you continue the curve, you’ll see that this graph predicts that we would be entering a new financial crisis, oh, right about now. Too bad I didn’t read this book a couple of years ago.


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