Tuesday, November 03, 2009

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.