I was wrong
on that. I admit it. My call was perhaps a little flawed in logic, presumptuous,
based on assumptions that banks were choosing not to lend when perhaps it was
the economy not wanting to borrow.
I also
commented in that post that margin loans were approaching critical levels. When referring to critical levels I am asserting the fact that "available credit" is almost at empty! Following this point means
the equities rally that has been fuelled by surging margin lending may be a ride about to come to an end. It never ceases to amaze me how, human herd behaviour
lines up time and time again for ultimate beat downs. Insanity rules in a
financial market where mania and greed dominate decisions rather than facts and
figures.
The insanity
and mania produce a confidence and misguided feeling of stability that triggers
gyrations and volatility if growth is not sustained. It really is a case of everything
is ok… UNTIL IT’S NOT!
My calls of
a market correction, a substantial one which sees the DOW down to 10,000-12000 points
was made on the psychological effect of a slowing of credit growth irrespective
of whether this is bank imposed or economy imposed. I have also been wrong on
that prediction though I feel if the Fed does not undo the taper, increase QE
and reduce the interest on excess reserves the market deleveraging begins and the equities market moves to the downside.
It may only
need to start as a snowball but this may be enough to turn it into an avalanche. I
write this blog after being triggered by a discussion/debate I had with a guy
on twitter that goes by the handle @azizonomics. John Aziz is a bright economic
thinker who is or appears to be attached to the Keynesian approach as the way to
solve a period of economic recession/depression.
Taking a
look in the rear view mirror at history, John stated that the Keynes solution
of deficit spending “began to take effect in 1931/32 and that 1932 was the year
of recovery”. Debate raged as a tweeted response fired back “what recovery?..
it crashed in 1937”
At this
point I entered the debate raising the “forgotten depression” of 1921/22. The
points I made are discussed below but largely use the defining tightening
monetary policy and Government budget surplus produced a recovery in less than
2 years. I pressed John Aziz on the lack of recovery in Japan with it’s
extensive QE policy which produced a “lost decade”. The fact that we are now
more than 5 years into the greatest monetary policy experiment the global
economy has ever seen, but still signs of growth are both sporadic and based on
questionable data such as new GDP calculation methods for the USA.
The issue I
have with those that are attached to Keynesian economics is that many of the
supporters refuse to examine and analyse the depression of 1920/21. During that
period industrial production was down 14%, real GDP was down 10% , unemployment
topped 12% and commodity prices were down between 30 and 40% depending on what
data you choose to use for analysis. Surely no one would argue these conditions
are an economic nightmare!
In response
to this the Federal Government took action and produced a budget SURPLUS. In
conjunction to the SURPLUS the Federal Reserve TIGHTENED monetary policy and
the economy went through a short “acute” depression before recovering to make
way for a period known today as the “roaring 20’s”.
The policy
mix imposed on the economy in a time of high unemployment, huge falls in GDP,
industrial production and commodity prices was a budget SURPLUS and a Fed
TIGHTENING of monetary policy. The policies implemented today by the Fed and
supported by commentators like John Aziz are almost the complete opposite to
the policies that yielded a result in which economic pain lasted less than 2
years and gave way to a golden era for the USA economy.
The fact is
when President Harding took office in 1921, the USA economy was facing high
unemployment, runaway inflation and had plummeted into a deep depression. Sure
the inflationary argument and debt deflationary argument can be made to say
economic conditions are different today than they were in 1921. If my critics
debate me on that point I would say that yes inflationary numbers are
different, but so is the way the global economy functions today v 1921.
In stating
the above case and taking the contrarian side of the Keynesian debate I run the
risk of coming under attack that the “roaring 20’s” made way for the depression
of the 30’s. I wish to point out that in my humble opinion the policies both
fiscal and monetary were a mixed bag of good and bad policies as the decade
progressed.
The post WWI
marginal tax rate reduction from a high marginal rate of 77% (to fund the war
effort) was drastically reduced to 25% by 1925. The period also saw tariff protection
offered to the farming industry as well as a concerted effort to produce a
budget surplus. The theme of the Harding and Coolidge Presidential periods was
one that promoted private sector growth by reducing the ways government could
intrude on private business operations.
The policies
above set the economy on a path of economic growth and prosperity. The period
ushered in a golden era of new technologies, mass production and a reallocation
of resources into channels which provided economic growth with inflation rates
that topped out at 2.3% amongst scattered years of deflation! The period also
provided massive opportunities for the middle class, something that is sadly
being eroded by the policies of today.
Below is the
historical inflation data for analysis.
Here is the
GDP data recorded for the corresponding period that shows the growth in GDP
from 1923-29.
So what caused
the depression? As Hyman Minsky put it in his Financial Instability Hypothesis,
sustained periods of stability are inherently and ultimately destabilizing. In
my opinion the Roaring 20’s was the classic model/period to highlight Minsky’s
Hypothesis which broke down the process from stability to instability. Minsky’s
hypothesis broke the stability/instability transition into three separate
stages of debt finance phases, Hedge, Speculative then finally destabilizing
Ponzi.
In my
opinion, the early growth post 1921 was generated by a reduction in the
excessively high marginal tax rates to a normalised rate of around 25%, a
balanced budget and an interest rate policy that had been tightened to curb the
runaway inflation.
As the
economy gained traction and turned positive, the behavioural and psychological
aspects of human nature manifested itself. The seemingly stable economy was
beginning to shift into the second stage of Minskys debt phase of speculation.
At this point the economy was experiencing huge transformations, technological,
infrastructure, industrialisation and urbanisation. Money/credit/debt was
needed to finance this growth.
Speculation
became a part of the economy as the Federal Reserve expanded credit, by setting
below market interest rates and low reserve requirements that favoured big
banks. Sound familiar? During this period the money supply actually increased
by around 60% during the time following the 1920/21 recession.
By the
latter part of the decade "buying on margin" entered into the
American investment strategy and the Ponzi stage Minsky described had begun.
The latter part of the 1920’s saw more and more Americans over-extend
themselves to speculate on the soaring stock market and expanding credit. The Ponzi
stage was reaching its peak as margin loans reached unsustainable levels.
Although the crash that began in 1929 was a surprise to many, a retrospective
analysis and application of Minsky’s Instability hypothesis nails the process
stage by stage.
So the way I
see it is Minsky recognises the human nature elements that affect economic
decisions and therefore how the economy grows and why it collapses. Minsky
identifies and includes behavioural/psychological factors such as greed, manias,
panic and debt deflation mentality. In identifying these and including these
Minsky taps into the human aspects that contribute greatly to the manifestation
of economic cycles of boom and bust.
It appears
to me that Hyman Minsky has a better command of human nature both behavioural and
psychological influences on the economy than Keynes. The wealth effect is
highly dependent on the willingness for both banks to lend and also the desire
of people to borrow. In many ways the wealth effect attempts to alter behaviour
whereas Minsky correctly understands that human behaviour is largely
unpredictable as it is influenced by environmental, psychological and behavioural
factors prevailing at the time.
With all of this in mind, I am
wondering if John Aziz is a “debt deflation” believer as I noted his admission
that he got his inflation call wrong and only came to his error in his macro
studies post his prediction. I admire the courage to admit error of judgement.
I do, however, find it difficult to see how one
can be a debt deflation believer whilst supporting massive deficits and easy
monetary policy designed to entice more debt and borrowings. It appears obvious
that deficits and easy monetary policy would be largely ineffective compared to
a solution that aims at debt reduction not debt promotion.
With all of
this in mind I agree with my former professor Steve Keen. If the economy is too
weak to tighten monetary policy and raise interest rates then surely a debt
forgiveness or jubilee is needed. How this is implemented in a fair manner is a
completely different discussion. Perhaps this blog may spark debate and open up
an explosion of ideas and potential solutions. Whatever is achieved from this
blog, this topic needs debating because the current path is likely more
destructive and obstructive to recovery than it is constructive and helpful.
