Thursday, January 22, 2009
Edward Chancellor is the author of Devil Take the Hindmost and a senior member of GMO’s asset allocation team.
Governments around the world are resorting to extreme measures to stave off deflation and depression. Fiscal and monetary stimulus on a grand scale is prescribed by Keynesian and monetarist economists alike. But there’s a danger that such moves could hinder the cleansing process of the bust. Although the contraction may be mitigated, the result of depression economics tends to be weak economies overburdened with government debt. (There are now clearly two sides in the field, one is Keynesians who believe fiscal and monetary stimulus will be necessary and appropriate to revive the economy. The other side are the conservatives who believe that markets must be allowed to correct on its own accord, that bad companies must be allowed to fail. By intervening, it is usually borne by the government/taxpayers and reward shareholders and excessive risk takers. If we allowed Citi, Bank of America and AIG to fail, I shudder to think of the follow on effects. If that happens, the conservatives and market purists will not speak a word. If that happens, the US unemployment rate could have ballooned to 12% or 13% by now. If that happened, we can be damn sure that we will be dragging the entire global economy into a deep depression. Bailouts may be argued as necessary because of how the global economy is structured nowadays. No big bank failure will be localised. The nature of the defaults are different from 1930s or 1970s because it involves derivatives and very high leverage on capital. If we did not have the latter two components, yes, I think bad companies should be allowed to fail, better to use the supposed bailout funds to start new banks. But its not the case here, or will it ever be the case in the future.)
It’s common nowadays to dismiss the notion that an economy needs purging after a boom. This, after all, is what president Herbert Hoover’s Treasury secretary, Andrew Mellon, recommended in the early 1930s. "Liquidate labor, liquidate stocks, liquidate the farmers, liquidate real estate," Mellon is said to have declared. "Values will be adjusted, and enterprising people will pick up the wrecks from less-competent people." To give such advice today would be political suicide.
Doing nothing in the face of a credit bust, according to conventional wisdom, is to replicate Hoover’s misguided policy. In fact, Hoover never followed Mellon’s advice. In his book, America’s Great Depression (1963), economist Murray Rothbard describes how Hoover prided himself on being the first American president to use all available tools to combat a depression.
After the 1929 stock market crash, Hoover persuaded business leaders to maintain wages. He instituted policies to support agricultural prices and halt farm foreclosures. Immigration was restricted to preserve jobs for Americans. Interest rates were lowered and government spending increased. In 1932, Hoover’s last year in the White House, the federal deficit was 4.7 percent of GDP, slightly higher than it was in 1933 after president Franklin Roosevelt took the helm.
Rothbard concludes that during Hoover’s presidency, "for the first time, laissez-faire was thrown boldly overboard, and every government weapon was thrown into the breach." Yet the main consequence of Hoover’s anti-depression policy was to bolster real wages in a time of severe deflation. As a result, American labor became uncompetitive, thereby damaging employment, business profits and investment.
Conventional wisdom holds that the depression was vanquished by Roosevelt’s New Deal. In fact, unemployment remained high, and the economy didn’t properly recover until after the U.S. entered World War II. Economist Gene Smiley, like Rothbard an adherent of the free-market Austrian school of economics, provides a cogent critique of the New Deal in his book Rethinking the Great Depression (2002). Acting under the erroneous belief that the depression was created by excessive production and too little consumption, Roosevelt’s National Recovery Administration embarked on an ambitious attempt to fix prices and output. The NRA was a flop. By the end of 1934, unemployment was 21.7 percent. Later, Roosevelt engaged in a "soak-the-rich" tax policy and instituted an "excess profits tax." The decade from 1930 to 1940 is the only one in U.S. history when corporate investment declined. Smiley concludes that the New Deal created a "depression within a depression."
At least the policies adopted after the bursting of Japan’s "bubble economy" in the early 1990s prevented a severe depression and deflation. Government spending soared as a massive public works program covered the country with cement. Yet Japan also prevented the bust from performing its role of creative destruction. Businesses were reluctant to shed workers and renege on their lifetime employment guarantees. Japanese authorities encouraged banks to supply new credit to weak companies. This served to worsen the bad-debt problems within the banking system, which came to a head in the 1997 financial crisis. Academic research suggests that the increasing dominance of certain industries by so-called "zombie" firms tended to depress job creation and lower productivity. Product prices in zombie industries were low because of excess competition. Low prices and high wages reduced profits and discouraged new investment. ( I was working for Nomura, the biggest Japanese securities firm then from 1988-1991, and I can say that Japan did one thing right: government spending increase. They did many things wrong which was what dragged the recession into a stagflation period for over ten years: they did not force bad banks to fail; the worst was allowing banks to not act on bad debts thus keeping technically insolvent businesses alive for years; the life-time employment culture caused many companies not to restructure; not allowing the banks to seek foreign investment to replenish their capital; not allowing foreign ownership of banks and most other companies which would have restructured many of them and given them much needed capital. Hence for the writer to use the Japan experience to somehow link it to the futility of what the US government agencies are doing is flawed, very flawed. The bubble was deflated in stocks and property, stocks crashed because its a relatively open market with foreign participation, property died slowly as there were too many regulations preventing foreign ownership.)
Depression economics can also trigger a growing dependency on government life support. As a result, it becomes difficult to normalize policy. The economy is vulnerable to crash when taxes are raised to reduce the deficit or when monetary policy is restricted to avoid inflation. This happened after Roosevelt instituted a fiscal and monetary tightening in 1937. Japan’s economy also collapsed in 1997 after the government increased consumption taxes. After two decades, Japan’s monetary authorities haven’t succeeded in normalizing interest rates, and economic growth has never approached its prebubble level.
So what are the dangers of our current anti-depression policies? The greatest risk is that they interfere with the clearing process, or liquidation, which is necessary for economies to regain equilibrium. Households in the U.S. and the U.K. have consumed too much and saved too little in recent years. This has to be reversed. Yet the recent decision to cut British consumption taxes doesn’t help. The era of low interest rates stimulated excessive home construction and auto purchases. If the downturn is to work its cure, it makes little sense for Washington to bail out Detroit or put a floor under home prices. If General Motors Corp. becomes a zombie, then American employees of Japanese car manufacturers are likely to suffer. Now that banks around the world are receiving injections of public money, it’s inevitable that the authorities will play an increasing role in the allocation of capital. They are likely to do an even worse job than the Wall Street casino. Governments will pressure banks to lend to households and businesses even when it makes little business sense. The French government has offered money to its banks if they increase their lending next year. Immediately after the British government took control of the Royal Bank of Scotland, the bank announced a moratorium on mortgage foreclosures. Anti-depression policies are also in danger of stoking economic nationalism. French President Nicolas Sarkozy has proposed a €20 billion ($27 billion) fund to support national champions. Government support for stricken industries, whether in Detroit or elsewhere, conflicts with the principles of the World Trade Organization.
It’s well known that the Great Depression was exacerbated by tariffs, exchange controls and competitive currency devaluations. But that doesn’t mean modern politicians won’t repeat this disastrous course. Russia recently announced import duties on used cars, while India raised tariffs on steel and soybean oil. Last but not least, the massive fiscal and monetary bailout threatens to destabilize government finances. At the latest count Washington’s commitments to fight financial fires amounted to some $7 trillion, according to Bloomberg. The British government is proposing a budget deficit equivalent to 8 percent of next year’s GDP. Whitehall is also supporting banks whose loan book is a multiple of Britain’s economic product. Monetarist economists, such as Federal Reserve Board chairman Ben Bernanke, have long promised that monetary policy has the right tools to deal with any threat of depression. Yet Iceland’s recent flameout shows what happens when the financial problems of a bust exceed the government’s available resources. ( Yes, deficit spending will shatter US balance sheet, but not doing it will leave a US economy grappling with social unrest, massive unemployment, and debilitate one of their most important industry, banking and international finance. Yes, the moves undertaken by the US will ensure a long but sure death for the USD, which is the way to penalise the US, by moving more and more US assets to foreign ownership. There will come a time when most US banks and even the IBMs, Procter & Gamble will be majority owned by foreign investors, and it will come sooner than you think. Unless the government go on a super diet of savings and increased productivity after this crisis is over, the US will be only a shadow of its former self in economic might in 5 years time.)
p/s photos: Sharon Chan Mun Chi