October 29, 2009, is the 80th anniversary of the market crash in the United
States that led to the Great Depression. Did the world learn the lesson of
1929?
Milton Friedman identified through exhaustive analysis of historical data the
potential role of monetary policy in shaping the course of inflation and
business cycles, with the counterfactual conclusion that the Great Depression
of the 1930s could have been avoided with appropriate Federal Reserve monetary
easing to counteract destructive market forces.
Friedman's counterfactual conjecture, though not provable, has been accepted by
central bankers as monetary magic to rid
capitalism of the curse of business cycles. It underpins the Alan Greenspan-led
Fed's "when in doubt, ease" approach all through his 18-year-long tenure, which
led to serial debt bubbles, each one bigger than the previous one. The final
one burst in 2007.
Most macroeconomists, including current Fed chairman Ben Bernanke, subscribe to
the debt-deflation view of the Great Depression, in which the collateral used
to secure loans (or as in the current situation, the assets backing derivative
instruments) will eventually decrease in value from excessive debt, creating
losses to borrowers, lenders and investors, leading to the need to restructure
the loan terms or even loan recalls.
When that happens, macroeconomists believe, government intervention to supply
liquidity is both necessary and effective in keeping markets from failing.
The term debt-deflation was coined by Irving Fisher in 1933 to describe the way
debt and deflation can destabilize each other. Destabilizing arises because the
relation runs both ways: deflation causes financial distress for debt, and
financially distressed debt in turn exacerbates deflation.
This debt-deflation cycle is highly toxic in a debt-infested economy. The only
way to prevent it is not to allow liquidity to flow into debt.
Friedman held out the false hope that central bankers could negate
debt-deflation instability with wholesale liquidity injections.
Hyman Minsky in The Financial-Instability Hypothesis: Capitalist Processes and
the Behavior of the Economy (1982) elaborated the debt-deflation
concept to incorporate its effect on the asset market. He recognized that
distress selling reduces asset prices, causing losses to agents with maturing
debts. This reinforces more distress selling and reduces consumption and
investment spending, which deepens deflation. This has come to be known as the
Minsky Moment.
Friedman's counterfactual conclusions obscured the lesson the world could have
learned from the crash of 1929 and condemned the world to face another disaster
80 years later.
In all, four false counterfactual conclusions on the 1929 crash accepted as
economic truths have since given birth to an economics of instability:
False:Aggressive monetary easing measures can save the economy
from business cycle recessions. This conclusion led central bank monetarism to
finance unsustainable debt bubbles. And only if the Fed had intervened earlier
and firmly in 1929, it could have prevented the depression (Friedman). Bernanke
is discovering in 2007 that this is not true.
False: World trade must be maintained to keep depression at bay.
Under predatory terms of global trade based on currency hegemony, fueled by
regulatory and wage arbitrage, world trade is the cause of global imbalance.
Fact: Global free trade has been the prime cause for domestic
unemployment. As global free trade grew dramatically, unemployment rose in both
the US and Chinese economies.
Solution: New terms of trade must be introduced to reverse the
adverse impact of international trade on employment, wages and domestic
development. Restore international trade to augment rather than preempt
domestic development.
False: Only capital can create employment.
Fact: Under conditions of overcapacity, only full employment with
high wages can create savings/capital. Say's law (supply creates its one
demand) holds only with full employment. Without global full employment,
comparative advantage in free trade is merely Say's law internationalized.
False: Comparative advantage in free trade is a win-win formula
for both trading partners.
Fact: Comparative advantage has a fatal cost to the partner who
forgoes technological development in exchange for economic efficiency in trade.
Ricardo, in analyzing trade between Britain and Portugal, failed to point out
that by focusing on producing cloth, which required mechanization, British
gained a mechanized economy that gave it a modern navy to take over the
Portuguese empire. Because Portugal elected to produce wine in exchange for
British cloth, it remained a technologically underdeveloped agricultural
economy and in time ceased to be a major power.
Solution: In a world order of sovereign states, weak national
economies must seek redress through economic nationalism.
Henry C K Liu is chairman of a New York-based private investment group.
His website is at http://www.henryckliu.com.
(Copyright 2009 Asia Times Online (Holdings) Ltd. All rights reserved. Please
contact us about
sales, syndication and
republishing.)
Head
Office: Unit B, 16/F, Li Dong Building, No. 9 Li Yuen Street East,
Central, Hong Kong Thailand Bureau:
11/13 Petchkasem Road, Hua Hin, Prachuab Kirikhan, Thailand 77110
