Vigilant Investor

NEW YORK — Wall Street was expected to plunge at the opening of trading Tuesday, extending its huge losses from last week and taking more cues from heavy selling that has spread throughout the world. Indicators showed the Dow Jones industrial average was set to fall by more than 500 points when trading begins.Fears of a recession in the United States that could pull down the global economy as well have infected markets around the world, and those declines further unnerved U.S. investors who were unable to trade Monday, when Wall Street was closed for Martin Luther King Jr. Day. Meanwhile, U.S. bond prices soared as investors fled the stock market, and the price of oil skidded as investors dumped futures in the belief that a recession would slash demand for energy.

It looks like the markets are finally taking the credit crisis and recessionary risks seriously. It was as if a switch was flicked at the turn of the year, from “will there be a recession?”, to “Yikes! A recession! How long and how deep?”

Our answer? Deep. Long. And very liquid.

That’s a prediction based on Ben Bernanke’s own work and views about mistakes made prior to the Great Depression. And that’s a subject that divides folks into two camps about what should be done today; Camps that function in entirely different paradigms, each with its own set of rules.

The popular view of the Great Depression is that of Ben Bernanke. This camp believes the Fed did not provide sufficient liquidity (e.g. freshly minted credit and money) to inoculate the economy from the Great Depression. If only the policy makers of that age had properly acted, disaster would have been averted, or so the theory goes.

Today, that’s what is generally assumed, and history classes teach of Hooverville shanty towns, named to blame President Hoover for not taking aggressive enough action to prevent the Great Depression.

Instead, it was FDR, in this popularized version of history, who swooped in to save the ailing economy from the depths, a hero willing to dictate to an economy the hard choices required to save us from ourselves. Of course, the duration and severity of the problem is always attributed to failures prior to FDR, leaving our hero with a situation that would have been insurmountable to mere mortals of his day.

As for how the Great Depression came to be, it all falls to liquidity. This prevailing wisdom concludes, if only the banking system had remained liquid, such a disaster would have been averted. Lack of liquidity, its argued, was the catalyst setting a series of unfortunate events in motion.

At about the same time, John Maynard Keynes’ economic theories were growing popular. Keynes believed in a theory that suggested man’s fallibility — his animal spirits — had caused poor economic decisions. It was overzealous greed that lead to the stock bubble. It was over-reactions to the bust that compounded economy-killing error-after-error, all of which set the Great Depression in motion. This irrational nature of humans explained the initial stock bubble, its subsequent crash, the panics, the bank lines, the job losses, the crushing humiliation, etc. Keynes’ proposed centralized action provided a blueprint for rescue, as well as for policy engineering that would both inoculate and manage the economy away from such irrational behavior in the future.

Generally speaking, that prevailing theory remains today, and its one we see reflected in the Fed’s emergency actions to date, as well as today’s emergency cut in the Fed Funds Rate by .75% — and it explains the common complaint that the Fed has acted, once again, too little and too late!

Our camp, on the other hand, views the Great Depression as the consequence of compounding errors on top of previously made errors – all instigated by sloppy policy action at the Fed. That’s because it was the Fed itself that had ginned-up irrational exuberance during the roaring 20’s by briskly expanding money supply and credit.

This was partially done in response to World War I in order to restore fiscal order for its allies. At the time, Britain was functionally bankrupt and had destroyed the pound as it financed its war efforts any way it could – heavily through inflation. With precious metal still backing its currency, after the War the British Treasury was in trouble, as was its banking system. (Such are, after all, the just deserts of such a stupid, ego fueled war.)

In response to a deteriorating British Pound, the Fed — itself a banking cartel sharing many private interests with Great Britain’s bankers — along with bedfellows in the U.S. and British Governments, all thought it made sense to devalue the U.S. dollar to strengthen Britain’s situation.

Consequently, along with the flood of liquidity during the late teens and early 20’s came a Tsunami of confidence in the economy and the impression of newfound wealth as players mistook monetary expansion for genuine production-based growth, as they are always prone to do with any inflationary environment. Errors began to compound and cluster, and soon enough, Florida Real Estate boomed, bubbled, and burst. The equity markets joined in the hoorah as it rocketed into the sky.

But, as is always the case, the high tide of credit and easy money can only last so long before the consequences are exposed when the tide goes back out. The trigger then, as it has been recently, was the requisite retrenchment of easy-money policy. In the 1920s this phenomenon was held further in check by the fact that the U.S. dollar was entirely redeemable in gold at $20 to the ounce. In other words, bank insolvency would be exposed as dollar holders would redeem their notes for the gold they expected to be held in reserve.

Since much of the activity taking place in the economy in such environments is only viable so long as the easy money is forthcoming, as the easy money pace plateaus or recedes, the activity that grew on the back of the expansion collapses on itself. And in 1929 boy, did it ever! Unfortunately, today we suffer a more distended fate with the dollar having absolutely nothing backing it to anchor monetary authorities or the economy to a healthy reality!

With boom comes bust, and usually in proportion to the distention of the boom. And so it was in 1929, with the economy suffering from massive misallocation of resources away from productive activity, the stock market was exposed for being irrationally priced. In other words, it had been driven largely by easy-money circulating through the system, not genuine, rational production.

Ironically, that is where the relevance to our story today begins.

At any rate, while few have bothered to listen to our camp’s warnings about the consequences to the credit and business-cycle from monkeying with credit and money, our line of reasoning (classical / Austrian based economic thought) provides the most rational explanation for how and why we got where we are, and where we are heading. (Feel free to peruse Vigilant Investor archives for evidence or our rational thinking dating back to April 2005.)

As such, when we look back to Hoover and FDR, we see a government intervening and compounding the errors that caused the market to plunge in 1929. What should have been a poignant recession as consequence of the previous compounded errors during the 1920s was instead extended.

How so?

The inherent nature of credit and money manipulation is to confiscate wealth from the productive sector and reallocate it to the go-go sectors that are by themselves unneeded and unsustainable (e.g. what’s bubbling). That’s what is exposed during any economic bust; hence the natural corrective action is to — believe it or not — do NOTHING. The best thing is to simply let the dust settle, to let the losses cleanse themselves from the marketplace, and to let productivity-oriented order reassert itself in the economy. This directs all actors on the micro level to the most economically rational use of their limited and valuable resources – to where they were needed all along, and away from where they had been redirected into unsustainable ventures. Simply, failing and idle assets are efficiently freed up to be returned towards their most productive uses, thus ending their drag on the economy.

Looking to today as an example, we can clearly see a massive clustering of errors in all things related to housing, mortgages, and even banking, each exposed as naked to one and all! (I expect a great deal more are to come, with revolving credit and commercial / retail real estate heading off the same cliff as housing, followed by trouble in default-related derivatives!) This is virtually no different than what was exposed after the boom of the 1920s as the economy collapsed, with the exception that our situation today is far more complex and dramatically more distended.

How did we get here? We can thank a free-floating, unbacked credit and currency expansion colliding with modern financial technology. This lead many pundits to promote a belief that risk was sufficiently intermediated in ways that inoculated the economy like never before, a new era justifying all sorts of valuations and leverage.

But our situation had become a fiction no different from what transpired in the 1920s. If our readers have doubts about such harsh sentiments, I encourage you to run those doubts across the context of what’s transpired in the credit markets over the last 12 months - - all of which blindsided the conventional wisdom dominating popular economic theory. How many $ trillions will have to vanish before we conclude certain assumptions were exceptionally wrong, and that perhaps we’ve fallen victim to believing in a false paradigm? Indeed, all reports suggest our economy’s ability to sustain misallocations into the stratosphere are being exposed as unsustainable – and in our opinion, predictably so.

The question today is as it was at the start of the Great Depression (at least as it was articulated by Austrians such as Hayek and Mises): Should the authorities be confiscating yet more wealth from our productive sectors in order to support other sectors of the economy that were never sustainable from the start without the subsidy of monetary redistribution? Is a .75% cut and more monetary easing the answer, as many demand? Are President Bush’s proposals for fiscal stimulus too little compared to what’s needed, as many have suggested from the moment they were proposed?

The answer lies in what followed the bust of 1929-1939 as the Great Depression deepened. The Hoover administration, contrary to popular belief, did not sit idle, nor did the Federal Reserve of its day. Murray Rothbard’s seminal work, America’s Great Depression, clearly notates how Fed liquidity was dramatically forthcoming as the situation unfolded, and also that much of the action was as useless as pushing on a string. Whatever leaked through to the economy actually served only to sustain and compound previous errors. He was further critical of Hoover’s administration for magnifying the duration, breadth, and intensity of what followed. Rothbard provides no policy panacea for fixing the depression, other than letting it clear as a valuable lesson against having intervened in the first place, which set the whole mess in motion.

As such, Rothbard’s book ends before FDR, making the dramatic statement that the actual Depression had arrived and all FDR contributed was a compounding of Hoover’s errors. Functionally, Hoover’s folly was sufficient to make the point that command, state-run economies are doomed to fail for their own reasons, and therefore such policies only to prolong depressionary busts. FDR’s massive intervention into the economy exponentially exacerbated Hoover’s errors, as evidenced by the ultimate severity of the Great Depression.

We don’t need to recount history of FDR’s policy intervention, although our previous post “Give a man a job! Stupid policy begets lousy results” provides valuable detail. Let it suffice to say, any stimulation packages that confiscate more wealth from the productive sector in order to reallocate it for the purpose of lessening the pain are doomed to create exactly what they purports to fix – more pain. Redirecting productive wealth away from productive activity is the problem, not the solution!

And that lies at the core of where we’re likely heading today. We hold that “the other camp” fails to fully understand what productive growth is and how it comes to be. We’ll save that discussion for later, but as a play on Bill Clinton’s pivotal 1992 election slogan, well summarize it as “Its the Savings, Stupid”.

Unfortunately our policy makers fear savings as the antithesis to “consumption”, their Holy Grail of economic objectives. No doubt, they’ve converted the economies of many major nations to place emphasis on consumption as the primary growth driver to the extent they’ve justified unsustainable debt loads, as well as ridiculous credit and money supply creation, all of which are now imploding. As if we could have ever “spent our way to wealth” and “indebted ourselves to riches!”

As this high bubble tide continues recede and expose all the consequent naked economic activity that is inherent to such sloppy thinking, remember what we’ve just pointed out. Consider the consequences of the prevailing wisdom and what it implies.

Whatever you do, avoid auto-pilot means and method. Think it through!

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