Infographics: The World's Most Famous Case of Deflation: The Great Depression Part 1

A glimpse of the deflationary epoch known as the Great Depression via the infographics provided by the Visual Capitalist

The Great Depression was the most severe economic depression ever experienced by the Western world.

It was during this troubled time that the world’s most famous case of deflation also happened. The resulting aftermath was so bad that economic policy since has been chiefly designed to prevent deflation at all costs. 

Setting the Stage 

The transition from wartime to peacetime created a bumpy economic road after World War I.

Growth has hard to come by in the first years after the war, and by 1920-21 the economy fell into a brief deflationary depression. Prices dropped -18%, and unemployment jumped up to 11.7% in 1921.

However, the troubles wouldn’t last. During the “Roaring Twenties”, economic growth picked up as the new technologies like the automobile, household appliances, and other mass-produced products led to a vibrant consumer culture and growth in the economy.

More than half of the automobiles in the nation were sold on credit by the end of the 1920s. Consumer debt more than doubled during the decade.

While GDP growth during this period was extremely strong, the Roaring Twenties also had a dark side. Income inequality during this era was the highest in American history. By 1929, the income of the top 1% had increased by 75%. Income for the rest of people (99%) increased by only 9%.

The Roaring Twenties ended with a bang. On Black Thursday (Oct 24, 1929), the Dow Jones Industrial Average plunged 11% at the open in very heavy volume, precipitating the Wall Street crash of 1929 and the subsequent Great Depression of the 1930s. 

The Cause of the Great Depression 

Economists continue to debate to this day on the cause of the Great Depression. Here’s perspectives from three different economic schools: 

Keynesian: 

John Maynard Keynes saw the causes of the Great Depression hinge upon a lack of aggregate demand. This later became the subject of his most influential work, The General Theory of Employment, Interest, and Money, which was published in 1936.

Keynes argued that the solution was to stimulate the economy through some combination of two approaches:

1. A reduction in interest rates (monetary policy), and

2. Government investment in infrastructure (fiscal policy).

“The difficulty lies not so much in developing new ideas as in escaping from old ones.” – John Maynard Keynes 

Monetarist: 

Monetarists such as Milton Friedman viewed the cause of the Great Depression as a fall in the money supply.

Friedman and Schwartz argue that people wanted to hold more money than the Federal Reserve was supplying. As a result, people hoarded money by consuming less. This caused a contraction in employment and production since prices were not flexible enough to immediately fall.

“The Great Depression, like most other periods of severe unemployment, was produced by government mismanagement rather than by any inherent instability of the private economy.” ― Milton Friedman 

Austrian: 

Austrian economists argue that the Great Depression was the inevitable outcome of the monetary policies of the Federal Reserve during the 1920s.

In their opinion, the central bank’s policy was an “easy credit policy” which led to an unsustainable credit-driven boom.

“Any increase in the relative size of government in the economy, therefore, shifts the societal consumption-investment ratio in favor of consumption, and prolongs the depression.” – Murray Rothbard 

The Great Depression and Deflation 

Between 1929 and 1932, worldwide GDP fell by an estimated 15%.

Deflation hit.

Personal income, tax revenue, profits and prices plunged. International trade fell by more than 50%. Unemployment in the U.S. rose to 25% and in some countries rose as high as 33%.

Part 2 coming

Courtesy of: The Money Project

George Selgin: Ten Things Every Economist Should Know about the Gold Standard

At the Ideas for an Alternative Monetary Future (Alt-M) website, George Selgin director of the Cato Institute's Center for Monetary and Financial Alternatives, Professor Emeritus of economics at the Terry College of Business at the University of Georgia, and an associate editor of Econ Journal Watch addresses 10 controversial issues (myths & facts) surrounding the classic Gold Standard

1. The Gold Standard wasn't an instance of government price fixing. Not traditionally, anyway.
2. A gold standard isn't particularly expensive. In fact, fiat money tends to cost more.

3. Gold supply "shocks" weren't particularly shocking.

4. The deflation that the gold standard permitted  wasn't such a bad thing.

5.  It wasn't to blame for 19th-century American financial crises.

6.  On the whole, the classical gold standard worked remarkably well (while it lasted).

7.  It didn't have to be "managed" by central bankers.

8.  In fact, central banking tends to throw a wrench in the works.

9.  "The "Gold Standard" wasn't to blame for the Great Depression.

10.  It didn't manage money according to any economists' theoretical ideal.  But neither has any fiat-money-issuing central bank.

Below are four of my favorites: (bold mine)

1.  The Gold Standard wasn't an instance of government price fixing.  Not traditionally, anyway.

As Larry  White has made the essential point as well as I ever could, I hope I may be excused for quoting him at length:

Barry Eichengreen writes that countries using gold as money 'fix its price in domestic-currency terms (in the U.S. case, in dollars).'   He finds this perplexing:

But the idea that government should legislate the price of a particular commodity, be it gold, milk or gasoline, sits uneasily with conservative Republicanism’s commitment to letting market forces work, much less with Tea Party–esque libertarianism.  Surely a believer in the free market would argue that if there is an increase in the demand for gold, whatever the reason, then the price should be allowed to rise, giving the gold-mining industry an incentive to produce more, eventually bringing that price back down. Thus, the notion that the U.S. government should peg the price, as in gold standards past, is curious at the least.

To describe a gold standard as "fixing" gold’s "price" in terms of a distinct good, domestic currency, is to get off on the wrong foot.  A gold standard means that a standard mass of gold (so many grams or ounces of pure or standard-alloy gold) defines the domestic currency unit.  The currency unit (“dollar”) is nothing other than a unit of gold, not a separate good with a potentially fluctuating market price against gold.  That one dollar, defined as so many grams of gold, continues be worth the specified amount of gold—or in other words that one unit of gold continues to be worth one unit of gold—does not involve the pegging of any relative price. Domestic currency notes (and checking account balances) are denominated in and redeemable for gold, not priced in gold.  They don’t have a price in gold any more than checking account balances in our current system, denominated in fiat dollars, have a price in fiat dollars.  Presumably Eichengreen does not find it curious or objectionable that his bank maintains a fixed dollar-for-dollar redemption rate, cash for checking balances, at his ATM.

Remarkably, as White goes on to show, the rest of Eichengreen's statement proves that, besides not having understood the meaning of gold's "fixed" dollar price, Eichengreen has an uncertain grasp of the rudimentary economics of gold production:

As to what a believer in the free market would argue, surely Eichengreen understands that if there is an increase in the demand for gold under a gold standard, whatever the reason, then the relative price of gold (the purchasing power per unit of gold over other goods and services) will in fact rise, that this rise will in fact give the gold-mining industry an incentive to produce more, and that the increase in gold output will in fact eventually bring the relative price back down.

I've said more than once that, the more vehement an economist's criticisms of the gold standard, the more likely he or she knows little about it.  Of course Eichengreen knows far more about the gold standard than most economists, and is far from being its harshest critic, so he'd undoubtedly be an outlier in  the simple regression, y =   α + β(x) (where y is vehemence of criticism of the gold standard and x is ignorance of the subject).  Nevertheless, his statement shows that even the understanding of one of the gold standard's most well-known critics leaves much to be desired.

Although, at bottom, the gold standard isn't a matter of government "fixing" gold's price in terms of paper money, it is true that governments' creation of monopoly banks of issue, and the consequent tendency for such monopolies to be treated as government- or quasi-government authorities, ultimately led to their being granted sovereign immunity from the legal consequences to which ordinary, private intermediaries are usually subject when they dishonor their promises. Because a modern central bank can renege on its promises with impunity, a gold standard administered by such a bank more closely resembles a price-fixing scheme than one administered by a commercial bank.  Still, economists should be careful to distinguish the special features of a traditional gold standard from those of  central-bank administered fixed exchange rate schemes. 

5.  It wasn't to blame for 19th-century American financial crises.

Speaking of 1873, after claiming that a gold standard is undesirable because it makes deflation (and therefore, according to his reasoning, depression) more likely, Krugman observes:

The gold bugs will no doubt reply that under a gold standard big bubbles couldn’t happen, and therefore there wouldn’t be major financial crises. And it’s true: under the gold standard America had no major financial panics other than in 1873, 1884, 1890, 1893, 1907, 1930, 1931, 1932, and 1933.  Oh, wait.

Let me see if I understand this.  If financial  crises happen under base-money regime X, then that regime must be the cause of the crises, and is therefore best avoided.  So if crises happen under a fiat money regime, I guess we'd better stay away from fiat money.  Oh, wait.

You get the point: while the nature of an economy's monetary standard may have some bearing on the frequency of its financial crises, it hardly follows that that frequency depends mainly on its monetary standard rather than on other factors, like the structure, industrial and regulatory, of the financial system.

That U.S. financial crises during the gold standard era had more to do with U.S. financial regulations than with the workings of the gold standard itself is recognized by all competent financial historians.    The lack of branch banking made U.S. banks  uniquely vulnerable to shocks, while Civil-War rules linked the supply of banknotes to the extent of the Federal government's indebtedness., instead  of allowing that supply to adjust with seasonal and cyclical needs.   But there's no need to delve into the precise ways in which  such misguided legal restrictions to the umerous crises to which  Krugman refers. It should suffice to point out that Canada, which employed the very same gold dollar, depended heavily on exports to the U.S., and (owing to its much smaller size) was far less diversified, endured no banking crises at all, and very few bank failures, between 1870 and 1939.

6.  0n the whole, the classical gold standard worked remarkably well (while it lasted).

Since Keynes's reference to gold as a "barbarous relic" is so often quoted by the gold standard's critics,  it seems only fair to repeat what Keynes had to say, a few years before, not about gold per se, itself, but about the gold-standard era:

What an extraordinary episode in the economic progress of man that age was which came to an end in August, 1914! The greater part of the population, it is true, worked hard and lived at a low standard of comfort, yet were, to all appearances, reasonably contented with this lot.  But escape was possible, for any man of capacity or character at all exceeding the average, into the middle and upper classes, for whom life offered, at a low cost and with the least trouble, conveniences, comforts, and amenities beyond the compass of the richest and most powerful monarchs of other ages.  The inhabitant of London could order by telephone, sipping his morning tea in bed, the various products of the whole earth, in such quantity as he might see fit, and reasonably expect their early delivery upon his doorstep; he could at the same moment and by the same means adventure his wealth in the natural resources and new enterprises of any quarter of the world, and share, without exertion or even trouble, in their prospective fruits and advantages… He could secure forthwith, if he wished it, cheap and comfortable means of transit to any country or climate without passport or other formality, could despatch his servant to the neighboring office of a bank or such supply of the precious metals as might seem convenient, and could then proceed abroad to foreign quarters, without knowledge of their religion, language, or customs, bearing coined wealth upon his person, and would consider himself greatly aggrieved and much surprised at the least interference.  But, most important of all, he regarded this state of affairs as normal, certain, and permanent, except in the direction of further improvement, and any deviation from it as aberrant, scandalous, and avoidable.

It would, of course, be foolish to suggest that the gold standard was entirely or even largely responsible for this Arcadia, such as it was.  But it certainly did contribute both to the general abundance of goods of all sorts, to the ease with which goods and capital flowed from nation to nation, and, especially, to the sense of a state of affairs that was "normal, certain, and permanent." 

The gold standard achieved these things mainly by securing a degree of price-level and exchange rate stability and predictability that has never been matched since.  According to Finn Kydland and Mark Wynne:

The contrast between the price stability that prevailed in most countries under the gold standard and the instability under fiat standards is striking. This reflects the fact that under commodity standards (such as the gold standard), increases in the price level (which were frequently associated with wars) tended to be reversed, resulting in a price level that was stable over long periods. No such tendency is apparent under the fiat standards that most countries have followed since the breakdown of the gold standard between World War I and World War II.

The high degree of price level predictability, together with the system of fixed exchange rates that was incidental to the gold standard's widespread adoption, substantially reduced the riskiness of both production and international trade, while the commitment to maintain the standard resulted, as I noted, in considerably lower international borrowing costs. 

Those pundits who find it easy to say "good riddance" to the gold standard, in either its classical or its decadent variants, need to ask themselves what all the fuss over monetary "reconstruction" was about, following each of the world wars, if not achieving a simulacrum at least of the stability that the classical  gold standard achieved.  True, those efforts all failed.  But that hardly means that the ends sought weren't very worthwhile ones, or that those who sought them were "lulled by the myth of a golden age."  Though they may have entertained wrong beliefs concerning how the old system worked, they weren't wrong in believing that it did work, somehow.

Finally: 9.  "The "Gold Standard" wasn't to blame for the Great Depression.

I know I'm about to skate onto thin ice, so  let me be more precise.  To say that "The gold standard caused the Great Depression " (or words to that effect, like "the gold standard was itself the principal threat to financial stability and economic prosperity between the wars”), is at best extremely misleading.  The more accurate claim is that the Great Depression was triggered by the collapse of the jury-rigged version of the gold standard cobbled together after World War I, which was really a hodge-podge of genuine, gold-exchange, and gold-bullion versions of the gold standard, the last two of which were supposed to "economize" on gold.    Call it "gold standard light."

Admittedly there is one sense in which the real gold standard can be said to have contributed to the disastrous shenanigans of the 1920s, and hence to the depression that followed.  It contributed by failing to survive the outbreak of World War I.  The prewar gold standard thus played the part of Humpty Dumpty to the King's and Queen's men who were to piece the still-more-fragile postwar arrangement together.  Yet even this is being a bit unfair to gold, for the fragility of the  gold standard on the eve of World War I was itself largely due to the fact that, in most of the belligerent nations, it had come to be administered by central banks that were all-too easily dragooned by their sponsoring governments into serving as instruments of wartime inflationary finance.

Kydland and Wynne offer the case of the Bank of Sweden as illustrating the practical impossibility of preserving a gold standard in the face of a major shock:

During the period in which Sweden adhered to the gold standard (1873–1914), the Swedish constitution guaranteed the convertibility into gold of banknotes issued by the Bank of Sweden.  Furthermore, laws pertaining to the gold standard could only be changed by two identical decisions of the Swedish Parliament, with an election in between. Nevertheless, when World War I broke out, the Bank of Sweden unilaterally decided to make its notes inconvertible. The constitutionality of this step was never challenged, thus ending the gold standard era in Sweden.

The episode seems rather less surprising, however, when one considers that "the Bank of Sweden," which secured a monopoly of Swedish paper currency in 1901, is more accurately known as the Sveriges Riksbank, or "Bank of the Swedish Parliament."

If the world crisis of the 1930s was triggered by the failure, not of the classical gold standard, but of a hybrid arrangement, can it not be said that the U.S. , which was among the few nations that retained a full-fledged gold standard, was fated by that decision to suffer a particularly severe downturn?  According to Brad DeLong,

Commitment to the gold standard prevented Federal Reserve action to expand the money supply in 1930 and 1931–and forced President Hoover into destructive attempts at budget-balancing in order to avoid a gold standard-generated run on the dollar.

It's true that Hoover tried to balance the Federal budget, and that his attempt to do so had all sorts of unfortunate consequences.   But the gold standard, far from forcing his hand, had little to do with it.  Hoover simply subscribed to the prevailing orthodoxy favoring a balanced budget.  So, for that matter, did FDR, until events forced him too change his tune: during the 1932 presidential campaign the New-Dealer-to-be assailed his opponent both for running a deficit and for his government's excessive spending.

As for the gold standard's having prevented the Fed from expanding the money supply (or, more precisely, from expanding the monetary base to keep the broader money supply from shrinking), nothing could be further from the truth.  Dick Timberlake sets  the record straight:

By August 1931, Fed gold had reached $3.5 billion (from $3.1 billion in 1929), an amount that was 81 percent of outstanding Fed monetary obligations and more than double the reserves required by the Federal Reserve Act.  Even in March 1933 at the nadir of the monetary contraction, Federal Reserve Banks had more than $1 billion of excess gold reserves.

Moreover,

Whether Fed Banks had excess gold reserves or not, all of the Fed Banks’ gold holdings were expendable in a crisis.  The Federal Reserve Board had statutory authority to suspend all gold reserve requirements for Fed Banks for an indefinite period.

Nor, according to a statistical study by Chang-Tai Hsieh and Christina Romer, did the Fed have reason to fear that by allowing its reserves to decline it would have raised fears of  a devaluation.    On the contrary: by taking steps to avoid a monetary contraction, the Fed would have helped to allay fears of a devaluation, while, in Timberlake's words,  initiating a "spending dynamic" that would have  helped to restore "all the monetary vitals both in the United States and the rest of the world."

Read the rest here

1929 Stock Market Chart Parallels and Real Private Businesses Investing

Sovereign Man’s Simon Black makes a reasonable case for investing in real private business than to gamble in financial markets by showing this chart. 

Mr. Black eloquently writes:

But as we have pointed out before, world stock and bond markets are heavily manipulated, if not rigged, by central bankers who control the money supply.

Fundamentals no longer matter. If one single person (now Fed Chair Janet Yellen) says she will print, stocks go up. If she says she will taper, stocks go down.

This isn’t investing. It’s gambling. Financial analysis has been replaced by soothsaying and tasseography (reading the tea leaves), hoping to detect some hint in the direction that central bankers are leaning.

This is the chief reason why I seldom participate in public markets anymore; it seems ludicrous to pile on a giant tidal wave of paper currency and entrust central bankers with my investment returns.

Not to mention, it’s uncertain how long they can keep this party going as the following (rather scary) chart shows. There’s an eerie parallel between the market’s performance today and the runup to the crash of 1929.

Financial markets dependent on Central Bank steroids is a real concern.

However, before I deal with investing in real private business, there has been an objection to the above chart.

Stock market bulls at the Businessinsider downplayed the above calling the former “flawed logic” by presenting another chart.

The bulls didn’t address how and why the nominal based chart pattern parallel of the 1929 chart had been “flawed”, but rather shifted their objection by framing another chart in terms of “percentage”. 

This devious way of challenging the original premise is called the alternative substitution—i.e. in behavioral finance, when people are faced with a difficult question, the response would be to  “answer a related but different question, without realizing that a substitution has taken place.”

History is no guarantee of future outcomes. From this premise we understand that patterns may just be patterns, whose outcomes may or may not repeat. I pointed years back how the father of fractal geometry, Benoit Mandelbroit advised people not to trust charts: (bold mine)

And in the fun-house mirror of logic of markets, the chartists can at times be correct...But this is a confidence trick: Everybody knows that everyone else knows about the support points, so they place their bets accordingly. It beggars belief that vast sums can change hands on the basis of financial astrology. It may work at times, but it is not a foundation on which to build a global risk-management system.

And if history does repeat, it will not be in exactitude of the past but rather as American author and humorist Mark Twain says History rhymes. 

And any repetition of history hasn’t just because patterns repeat, but rather such reveals of people’s underlying responses to certain conditions.

The reason “cycles” exists can be imputed or traced to on the admonitions of Spanish born philosopher and essayist George Santayana who wrote “Those who cannot remember the past are condemned to repeat it.”

Essentially what underscores a potential repetition of the 1929 scenario are the ‘real’ fundamentals behind them. 

Since US stocks have been rising driven mainly by massive debt accumulation (record net debt margin and various record bond market issuance), the question is at what or how much degree of additional debt load can the US economy and financial markets absorb in the face of rising yields of USTs just to push up stock market values? What if the capacity to absorb more debt hits the brick wall? What if the rate of return of stock markets will be eclipsed by the rate of increases in the cost of servicing debt, how will all these affect the stock market? 

You see, the mainstream thinks that debt is a free lunch thing that has no repercussions. This kind of thinking is a recipe to a rude awakening. 

Moreover, people hardly realize how the severe distortions from the easy money landscape has influenced earnings and economic coordination. With Fed Chairwoman Janet Yellen’s debut who appear to echo on policy path of  the previous chair Ben Bernanke on “tapering”, how will reduced monetary accommodation impact asset prices whose foundations have been built on easy money? The violent response in emerging markets have been manifestations of the drastically changing environment. What if a periphery to core will occur whose transmission mechanism will simply be higher rates in the face of massive debt?

As you can see these are questions that will determine whether the Dow Jones parallels of the 1929 today will be repeated.

Going back to real business. I don’t deny that investing in business should be a viable alternative. But my concern is that if earnings and the general economy has been massively skewed in favor of bubble blowing activities, putting up a business based on assessment of current conditions may lead to serious miscalculations therefore potential losses.  Besides, the current inflationary boom has already been inflating the cost of doing business. Unstable prices adds to the uncertainty. Compounding such uncertainty has been the equally fickle political environment.

So unless potential businesses would deal with some sort of niche, whose markets are going to be least affected from any downside economic volatility, investing in real business should be thoroughly scrutinized.

Importantly, if 1929 should ever rhyme, then this means shades of the great depression.

Wikipedia describes the post-1929 stock market crash

The Great Depression was a severe worldwide economic depression in the decade preceding World War II. The timing of the Great Depression varied across nations, but in most countries it started in 1930 and lasted until the late 1930s or middle 1940s. It was the longest, deepest, and most widespread depression of the 20th century.

In the 21st century, the Great Depression is commonly used as an example of how far the world's economy can decline. The depression originated in the U.S., after the fall in stock prices that began around September 4, 1929, and became worldwide news with the stock market crash of October 29, 1929 (known as Black Tuesday).

The Great Depression had devastating effects in countries rich and poor. Personal income, tax revenue, profits and prices dropped, while international trade plunged by more than 50%. Unemployment in the U.S. rose to 25%, and in some countries rose as high as 33%.

Cities all around the world were hit hard, especially those dependent on heavy industry. Construction was virtually halted in many countries. Farming and rural areas suffered as crop prices fell by approximately 60%. Facing plummeting demand with few alternate sources of jobs, areas dependent on primary sector industries such as cash cropping, mining and logging suffered the most.

A rhyming of 1929 stock market crash also means that even real businesses will take a hit.

Phisix and the SET: Why Talking Up the Embattled Stock Markets Won’t Work

Desperate stock market authorities from the Philippines and Thailand gave an advice today to panicking stock markets: CHILL.

From Bloomberg:

Stock exchanges in the Philippines and Thailand have moved to soothe investors after speculation the U.S. Federal Reserve may scale back bond purchases prompted selloffs by overseas investors.

Stock Exchange of Thailand President Charamporn Jotikasthira today urged investors not to panic, saying economic and corporate earnings growth in Southeast Asia’s second-biggest economy remains strong. The benchmark SET Index dropped to two-month low. Philippine Stock Exchange President Hans Sicat described the selloff as an “extreme overreaction.”

The Philippines benchmark index has slumped 11 percent and the Thai gauge 8.4 percent since May 22, when Fed Chairman Ben S. Bernanke said policy makers could consider reducing the pace of monetary stimulus if the nation’s labor market improves. Overseas investors have sold a net $414 million of Thai stocks and $147 million of Philippine shares this month.

“Foreign net selling is an extreme overreaction to Bernanke’s” outlook on possible stimulus cuts, Sicat said in a televised interview with ABS-CBN News today. “Technical corrections tend to be buying opportunities for others who are more conservative.”

Authorities from both former sizzling hot stock markets hardly provided sufficient explanations as to the relationship between the so-called proposed Bernanke’s stimulus cuts vis-à-vis the meltdown, and why the current market paroxysm has not been justified. 

A reduction of stimulus, and not a cessation, simply means of a partial tightening of monetary environment. This could be suggestive of the advent of high interest rate regime. 

And the brutal market reactions reveals of the extent of sensitivity to interest rate changes due to the degree of leverage employed and established around the Fed’s and local central banking "stimulus".

Simply said, financial markets have been deeply addicted to central banking steroids. Thus the recent stock market rout may be analogized as "withdrawal syndromes"

While it may be a coincidence that the emerging markets, represented by the Philippines (PCOMP-yellow) and Thailand (SET-green), turned the corner (dark blue vertical line) as shown in the above chart from Bloomberg since the May 22nd Bernanke spiel, in reality interest rates as impliedly measured by the US 10 year yields (USGG10YR-orange)  has already been in a sharp ascent since the early days of May. This means that Bernanke's babbles seem as trying to realign their policies to match or to reflect on the actions of the bond markets. 

Of course when authorities talk about strong “economic and corporate earnings” they are referring to the recent past events which blossomed under a low interest rate environment. The prospects of higher interest rates essentially changes this, which has been the reason for such violent response.

Finally, words of appeasement from authorities like the above sends shivers down my spine. That’s because they resonate with the responses made by authorities during a somewhat similar crash environment 

Here is a some quotes from the October 29, 1929 stock market “Black Tuesday” crash that ushered in the Great Depression:

Sept. 1929: "There is no cause to worry. The high tide of prosperity will continue." Andrew W. Mellon, Secretary of the Treasury

Oct. 14, 1929: "Secretary Lamont and officials of the Commerce Department today denied rumors that a severe depression in business and industrial activity was impending, which had been based on a mistaken interpretation of a review of industrial and credit conditions issued earlier in the day by the Federal Reserve Board". New York Times

January 21, 1930: "Definite signs that business and industry have turned the corner from the temporary period of emergency that followed deflation of the speculative market were seen today by President Hoover. The President said that reports to the Cabinet showed the tide of employment had changed in the right direction." News dispatch from Washington

May 1, 1930: "While the crash only took place six months ago, I am convinced we have now passed the worst and with continued unity of effort we shall rapidly recover. There is one certainty of the future of a people of the resources, intelligence and character of the people of the United States-that is prosperity." President Hoover

June 29, 1930: "The worst is over without a doubt." James J. Davis Secretary of Labor.

Sept. 12, 1930: "We have hit bottom and are on the upswing" James J. Davis Secretary of Labor.

What I am saying is that markets ultimately determine whether the interim trend and price levels are justified or not. 

Media’s appeal to authority and the subsequent denials made by authorities will hardly wish away any perceived problems the markets sees, which are currently being ventilated through the vehement feedback as expressed via steep price declines.

Following successive sessions of severe drubbing, the vastly oversold Phisix turned from a 164 point intraday opening decline to close higher by .78% or 58.21 points today (chart from technistock.com ).

The sharp rebound has little to do with pitching up of the marketplace, but about knee jerk responses to extreme technical conditions. 

Thailand’s SET slumped 2.13% today.

BIS: The Difference of Great Depression and the 2008 Crisis is Central Bank Inflationism

What’s the fundamental difference between the crisis of the Great Depression in 1931 and that of the US Mortgage crisis of 2008?

The Bank of International Settlement (BIS) gives an answer: central banking inflationism

Here’s the concluding remarks of William A Allen and Richhild Moessner from their recently published paper:

We have suggested a number of ways in which the financial crisis of 2008 was propagated internationally. We argue that the collateral squeeze in the United States, which became intense after the failure of Lehman Brothers created doubts about the stability of other financial companies in the United States, was an important propagator. The provision of large-scale swap lines by the Federal Reserve relieved many of the financial stresses in other countries that had followed Lehman Brothers’ failure. The unwinding of carry trades, particularly yen carry trades, is also likely to have transmitted market volatility to the countries that had been the destination of the carry trades when they were first put in place. It seems likely that, at the time of writing, there is still a large quantity of yen carry trades to be unwound.

In both crises, deposit outflows were not the only important sources of liquidity pressure on banks: in 1931, the central European acceptances of the London merchant banks were a serious problem, as, in 2008, were the liquidity commitments that commercial banks had provided to shadow banks. And in both crises, the behaviour of creditors towards debtors and the valuation of assets by creditors, were all very important. Flight to liquidity and safety was an important common feature of the crises of 1931 and 2008. In both episodes, the management of central banks’ international reserves appears to have had pro-cyclical effects.

However, there was a crucial difference, in that the supply of assets that were regarded as liquid and safe in 1931 was inelastic and became narrower with the passage of time, whereas in 2008, it could be, and was, expanded quickly in such as way as to contain the effects of the crisis. The understanding that the role of governments and central banks in a crisis is to enable such assets to be supplied was perhaps the most important lesson of 1931, and the experience of 2008 showed that it had been learned.

The difference has been Central Bank's asset-purchasing program or termed as credit easing policies a.k.a Quantitative Easing.

The BIS gets it.

The deflation camp based on premises of “aggregate demand” does not.

Perhaps a little more elaboration from the great Murray N. Rothbard who presciently wrote (What has Government Done To Our Money), [emphasis added]

But the central Bank, by pumping reserves into all the banks, can make sure that they can all expand together, and at a uniform rate. If all banks are expanding, then there is no redemption problem of one bank upon another, and each bank finds bank expansion of one bank upon another, and each bank finds that its clientele is really the whole country. In short, the limits on bank expansion are immeasurably widened, from the clientele of each bank to that of the whole banking system. Of course, this means that no bank can expand further than the Central Bank desires. Thus, the government has finally achieved the power to control and direct the inflation of the banking system.

In addition to removing the checks on inflation, the act of establishing a Central Bank has a direct inflationary impact. Before the Central Bank began, banks kept their reserves in gold; now gold flows into the Central Bank in exchange for deposits with the Bank, which are now reserves for the commercial banks. But the Bank itself keeps only a fractional reserve of gold to its own liabilities! Therefore, the act of establishing a Central Bank greatly multiplies the inflationary potential of the country.

The essence is, an inflationary or deflationary outcome depends largely on central bank directives.

Inflation expands the power of central banks, deflation does not. Guess which route central bankers are likely to chose? (Of course, this assumes that the market can still bear with the effects of central bank policies)

How Free Trade Saved The World From Depression

This from the Economist, (all bold highlights mine)

DURING the Great Depression, America’s protectionist Smoot-Hawley Act of 1930 raised tariffs on more than 900 goods. A series of retaliatory actions by other countries followed. The effect on global commerce was devastating. In the three years to June 1932, the volume of world trade shrank by over a quarter. No wonder, then, that the spectre of the worst recession since the Depression led many to fear another descent into protectionism and a similar decline in trade.

At first, the recession did hit trade hard. Global GDP fell by 0.6% in 2009 while the volume of world exports dropped by 12.2%. But whereas the Depression saw trade decline for at least four years, this time the rebound has been quick, and sharp. By May this year, emerging-economy members of the G20 were importing and exporting around 10% more than their pre-crisis peaks (see chart). Rich-world trade has recovered from the trough too, though it has not yet made up all the ground lost since the credit crunch began.

Trade has not been devastated by the raft of protectionist actions taken during the downturn. According to the World Bank, the rise in tariffs and anti-dumping duties explains less than one-fiftieth of the collapse in world trade during the recession. For the most part, the fall in trade reflected a drop in demand.

There is even some evidence that activity has rebalanced from the lopsided trade pattern that existed just before the crisis. Then, the share of emerging-world imports that came from rich countries had been on a steadily declining path. But now demand from emerging economies is helping to prop up rich-world exports to a larger degree than is commonly realised. According to IMF figures, of nine emerging markets in the G20, seven got a higher share of their imports from rich countries in 2009 than they did a year earlier. Just 59% of China’s imports came from rich countries in 2008, but this rose sharply to 66% in 2009. India obtained 42% of its imports from rich countries in 2008, but last year this rose to 47%.

That mutually beneficial pattern points to the importance of both rich and poor countries keeping their markets open, so that growth in one part of the world can help stimulate a recovery elsewhere.

Some observations:

People have learned from history (perhaps heeded George Santayana’s admonitions?)

Having sentiently benefited from the experience of trade, most of the world appear to embrace free-trade globalization as means of generating wealth. And as shown above, this is noteworthy especially in the emerging markets.

The proof of the pudding is in the eating. The best test of the conceptual assimilation of free trade is through a crisis, and free trade seems to have passed with flying colors.

The Economist doesn’t mention it, but the world’s growing acceptance of free trade, in my opinion, is largely aided by the shift to the information age. This seismic transition allows for real time communication, thereby reduce the instances of conflicts by open dialogue.

Like always, mercantilists have it wrong anew.

And with this we quote Mr. Ludwig von Mises in Liberalism,

To this question Ricardo's doctrine provided the answer. The branches of production distribute themselves among the individual countries in such a way that each country devotes its resources to those industries in which it possesses the greatest superiority over other countries. The mercantilists had feared that a country with unfavorable conditions for production would import more than it would export, so that it would ultimately find itself without any money; and they demanded that protective tariffs and prohibitions on imports be decreed in time to prevent such a deplorable situation from arising. The classical doctrine shows that these mercantilist fears were groundless. For even a country in which the conditions of production in every branch of industry are less favorable than they are in other countries need not fear that it will export less than it will import. The classical doctrine demonstrated, in a brilliant and incontrovertible way that has never been contested by anybody, that even countries with relatively favorable conditions of production must find it advantageous to import from countries with comparatively unfavorable conditions of production those commodities that they would, to be sure, be better fitted to produce, but not so much better fitted as they are to produce other commodities in whose production they then specialize.

Financial Reform Bill And Regime Uncertainty

``But the law is made, generally, by one man, or by one class of men. And as law cannot exist without the sanction and the support of a preponderant force, it must finally place this force in the hands of those who legislate. This inevitable phenomenon, combined with the fatal tendency that, we have said, exists in the heart of man, explains the almost universal perversion of law. It is easy to conceive that, instead of being a check upon injustice, it becomes its most invincible instrument.” Frédéric Bastiat, The Law

Yo-yo Markets And The Financial Reform Bill

Writing in the Wall Street Journal, hedge fund manager and author Andy Kessler seems right; the actions of the US markets, which directly affects other financial markets, will be in a state of a Yo-yo for as long as the US government continually intervenes to suppress market forces from revealing its true conditions.

Mr. Kessler writes[1],

``Call it the yo-yo market—from the top of the wall to the bottom of the pit and back—and you better get used to it. It's hard to tell which market moves are real and based on prospects for better profits, as opposed to moves that are driven by all the extraordinary government measures to prop up the world economy. Until a few things are resolved, you'd better learn the yo-yo sleeper trick—that is, keep spinning at the bottom without going up.”

Mr. Kessler appears to echo what we’ve been saying all along[2]---that politics has and will shape the outcome of the markets.

Mr. Kessler cites the pervasive impact of the Zero Interest Rate Policy (ZIRP), the assorted “crutches” or the guarantees, stimulus packages, and money printing, and importantly, the impact of the changes in the regulatory environment.

Since we had exhaustively discussed on the first two factors, in the light of the passage of the Financial Reform Bill[3], we’d tackle more on the aspects of the regulatory environment.

After having a rather promising start for the week, the US markets fell hard Friday after the ratification Financial Reform Bill. The losses virtually expunged on the early gains made whereby the net weekly result for the US S&P 500 had been a net loss of 1.21% (see figure 1).

Figure 1: US Global Investors[4]: Sectoral Performance

Nevertheless the degree of losses had been uneven, where some sectors of the S&P 500 have managed to escape the clutches of the selling pressures, such as the Consumer staples and the Technology sector.

True, correlation doesn’t automatically translate to causation. The Financial Reform bill may or may not have directly affected Friday’s performance.

However, given that the largest victim of the selloff had been in the financial sector, which is the target of the slew of new regulations, then I must argue that there could have been a substantial connection in the way the markets perceive how these purported reforms would affect the industry.

In other words, markets may have seen more downside risks to the industry, as a result of the law, and these perceptions have filtered into the other sectors.

Yet it’s simply amazing how some mainstream analysts fail to acknowledge of the vital role played by the regulatory environment in shaping the allocation of resources.

They seem to think that investment is merely consequence of waking up on a particular side of the bed which determines their “animal spirits”, or that, confidence is simplistically established as a function of random temperaments or moods—and largely detached from the coordination of consumers and producers in the marketplace.

Thus, many make specious arguments that new regulations won’t affect the business operations.

Importantly, the same experts fail to take into account that entrepreneurs invest with the aim to profit from providing or servicing the needs or desires of the consumers. Thus, a material change in the regulatory environment may affect the fundamental profit and loss equation. And the ensuing changes could also alter the feasibility of the operations of any enterprises, to the point which could lead to either closures, or impair the business operations. The net effect should be more losses and rising unemployment.

In short, business confidence is a function, not of some mood swings, but of property rights. Likewise confidence relative to investment should be predicated not just with the return ON capital, but with the return OF capital.

Regime Uncertainty From Arbitrary Laws

Economist Robert Higgs calls this reduced confidence factor as “regime uncertainty” where he argues[5] (bold emphasis mine)

``To narrow the concept of business confidence, I adopt the interpretation that businesspeople may be more or less “uncertain about the regime,” by which I mean, distressed that investors’ private property rights in their capital and the income it yields will be attenuated further by government action. Such attenuations can arise from many sources, ranging from simple tax-rate increases to the imposition of new kinds of taxes to outright confiscation of private property. Many intermediate threats can arise from various sorts of regulation, for instance, of securities markets, labor markets, and product markets. In any event, the security of private property rights rests not so much on the letter of the law as on the character of the government that enforces, or threatens, presumptive rights.”

Thus, to allege that new regulations will hardly be a factor in the investment environment would redound to utter detachment with reality.

Well, what can we expect from so-called ivory tower “experts” who seem to think that they own the monopoly of knowledge, via mathematical models and aggregates, when their sources of income depends on wages than from wagering on the dynamic trends of the marketplace? (Pardon me for the ad hominem, but perspectives are mostly shaped by interests)

Take the Great Depression (GD) of 1930s, which many prominent bears have anchored their projections as the probable direction of today’s market.

From the monetarist viewpoint, the GD had been all about monetary contraction, whereas from the Keynesian perspective this had been about falling aggregate demand. Both of which has been diagnosed by the incumbent Federal Reserve chief Ben Bernanke[6] as the major causes from which current policies have been designed to address. Yes—the solution? The printing press!

While both did have a role to play, the oversimplistic account of the GD fails to incorporate the havoc generated by the legion of intrusive laws enacted by the US government’s New Deal program, aimed at keeping prices at status quo ante or from adjusting to the realities of the unsustainable misdirection of capital from the inflation boom induced depression. These policies, which threatened property rights, had greatly exacerbated and prolonged the grim conditions then.

These laws included[7]:

1933 Agricultural Adjustment Act, National Industrial Recovery Act, Emergency Banking Relief Act, Banking Act of 1933 Act, Federal Securities Act, Tennessee Valley Authority Act, Gold Repeal Joint Resolution, Farm Credit Act, Emergency Railroad Transport Act, Emergency Farm Mortgage Act National Housing Act, Home Owners Loan Corporation Act

1934 Securities Exchange Act, Gold Reserve Act, Communications Act, Railway Labor Act

1935 Investment Company Act, Revenue Act of 1940, Bituminous Coal Stabilization Act, Connally (“hot oil”) Act, Revenue Act of 1935, National Labor Relations Act, Social Security Act, Public Utilities Holding Company Act, Banking Act of 1935, Emergency Relief Appropriations Act, Farm Mortgage Moratorium Act

1936 Soil Conservation & Domestic Allotment Act, Federal Anti-Price Discrimination, Revenue Act of 1936

1937 Bituminous Coal Act, Revenue Act of 1937, Act Enabling (Miller-Tydings) Act

1938 Agricultural Adjustment Act, Fair Labor Standards Act, Civil Aeronautics Act, Food, Drug & Cosmetic Act

1939 Administrative Reorganization Act

1940, Second Revenue Act of 1940

Figure 2: Wikipedia.org[8]: US Income Tax (left window), Higgs: Government Purchases (Current$) and Gross Private Investment (Current$) Relative to Gross Domestic Product (Current$), 1929–1950

For instance, one should also take into account how the surge in taxation (left window) to fund the explosion in government expenditures during the Great Depression (right window) contributed to stymie investments or production (see figure 2)

As Henry Hazlitt aptly described how taxes affect investment or production[9]

``When the total tax burden grows beyond a bearable size, the problem of devising taxes that will not discourage and disrupt production becomes insoluble.”

In other words, when the expectations for profits are reduced, borne out of the expectations of higher taxes or from other regulatory interdictions which places property rights at risks, then investments will obviously follow—and decline.

Therefore the regulatory and tax regime functions as crucial factors to the conditions of confidence in the marketplace.

Paradoxically, one function of the law is the avoidance of this “regime uncertainty”. But when the state is unclear about the direction of policies and regulation, the “means” can contradict the “end”. So, instead of stability, such laws could engender or promote “regime uncertainty”. Yet, these are commonplace feature of many arbitrary laws.

Take the recently enacted Financial Reform Bill, it has been reported to contain 2,319 pages (see figure 2)

Figure 2: Mark Perry[10]: Major Financial Legislation: Number of Pages

The sheer mountain of pages by itself would make the reformist law seem like a regulatory quagmire and appears appallingly political relative to the enforcement issues.

Heritage’s Conn Carroll explains[11],

``With the single stroke of a pen, President Barack Obama signed the Dodd-Frank financial regulation bill that set in motion 243 new formal rule-makings by 11 different federal agencies. Each of the 243 rule-makings will employ hundreds of banking lobbyists as they try to shape what the final actual laws will look like. And when the rules are finally written, thousands of lawyers will bill millions of hours as the richest incumbent financial firms that caused the last crisis figure out how to game the new system.”

The implication is that where financial firms compete, not to please customers, but to gain the favour of regulators, this essentially represents as the hallmarks of corporatism or crony capitalism.

Thus, the financial reform bill is likely to foster political privileges which entrenches the “too big too fail” institutions, who will profit from economic rent.

The litany of adverse effects from such ambiguous bill will be one of expanded corruption, lack of credit access for consumers, reduced consumers protection (in contrast to the purported letter of the law), regulatory capture, regulatory arbitrages, higher risks to taxpayers on greater risk appetite for the politically privileged firms (moral hazard issue), increased red tape via an expanded bureaucracy, higher compliance costs, more government spending and reduced competition which overall translates to broad based economic inefficiencies.

Yet the reformist law is also said not only to be opaque, but gives undue confiscatory power based on the whims of regulators.

Mr. Kessler writes[12], ``What is even more troubling is the prospect of government seizures built into the Dodd-Frank financial bill. This is much like the seizure of property from auto industry bond holders (denounced as speculators) in the bankruptcy of GM and Chrysler.

``Dodd-Frank also provides government leeway to seize firms it considers a systemic risk, without really defining what that systemic risk is. Why anyone would provide debt to large financial institutions (or auto makers) is beyond me, certainly not without demanding a huge premium for the seizure risk. The cost of capital for the U.S. economy is sure to rise, slowing growth.”

This means that Financial Reform bill also entails that the political favoured institutions are likely to become veiled instruments for political agenda of those in power.

And laws of this nature is what Frédéric Bastiat long admonished[13],

``But, generally, the law is made by one man or one class of men. And since law cannot operate without the sanction and support of a dominating force, this force must be entrusted to those who make the laws.

``This fact, combined with the fatal tendency that exists in the heart of man to satisfy his wants with the least possible effort, explains the almost universal perversion of the law. Thus it is easy to understand how law, instead of checking injustice, becomes the invincible weapon of injustice. It is easy. to understand why the law is used by the legislator to destroy in varying degrees among the rest of the people, their personal independence by slavery, their liberty by oppression, and their property by plunder. This is done for the benefit of the person who makes the law, and in proportion to the power that he holds.”

In short, arbitrary laws, as the Financial Reform bill, can function as instruments of injustice.

Thus, it is NOT impractical or improbable to argue that in the wake of the enactment of the Financial Reform Bill, the ambiguity and arbitrariness of the law and the increased politicization of the financial industry would likely result to greater perception of risks which may be reflected on the “Yo-yo” actions or a more volatile US markets.

At the end of the day, regulatory obstacles will likely compel capital to look for a capital friendly environment from which to flourish.

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[1] Kessler, Andy, The Yo-Yo Market and You, Wall Street Journal, July 16, 2010

[2] See How Political Tea Leaves Will Shape The Investment Landscape

[3] Bloomberg, U.S. Congress Passes Wall Street Regulation Bill, July 15, 2010

[4] US Global Investors, Investor Alert, July 16, 2010

[5] Higgs, Robert Regime Uncertainty, Why the Great Depression Lasted So Long and Why Prosperity Resumed after the War

[6] Bernanke, Ben Deflation: Making Sure "It" Doesn't Happen Here, Speech Before the National Economists Club, Washington, D.C. November 21, 2002

[7] Higgs, Ibid

[8] Wikipedia.org, Income tax in the United States

[9] Hazlitt, Henry Taxes Discourage Production, Chapter 5 Economics In One Lesson

[10] Perry, Mark ‘I Didn’t Have Time to Write a Short Bill, So I Wrote a Long One Instead,’ Part II The Enterprise Blog July 16

[11] Carroll, Conn Morning Bell: The Lawyers and Lobbyists Full Employment Act, Heritage Blog, July 16, 2010

[12] Kessler, Andy Ibid.

[13] Bastiat, Frédéric The Law