A deepening global deflationary depression

No matter where one looks, the collapse in global economic activity and prices is astounding in its speed and ferocity. A few examples, using manufacturing surveys, picked at random:


  • Between May and November, China's manufacturing PMI new orders index has crashed from 58,6 to 36,1.
  • The US manufacturing new orders index has meanwhile collapsed to a mere 27,9 – it stood at 54,3 as recently as July. The manufacturing PMI's prices component in the US has plunged from a 77 reading in August of this year to 25,5 in November, on the heels of the steepest decline in month-over-month headline inflation (deflation of 1% m-o-m) since the beginning of the CPI data series in 1947.
  • German new manufacturing orders have declined by 36,8% over just the past three months – with the most recent monthly contraction clocking in at an annualized pace of minus 48,2%.
  • In Japan, the PMI has declined to its lowest level on record – with the new orders index contracting to 27,3 from 44,1 a mere three months ago.

The litany of global woes is long, with emerging market economies on average in even worse shape than the industrialized nation economies, on account of their dependence on commodity exports, and incipient debt crises in response to collapsing currency values. The problem, as usual, is that too much debt was denominated in foreign currencies, which are now soaring against emerging market currencies.

Certain repeat default offenders like Argentina have seen credit default swap spreads on their sovereign debt soar to the stratosphere (5,000 basis points in Argentina's case – which is to say, it costs more than half of an Argentinian bond's face value to insure it against default for just one year).

One could list many more economic indicators that are indicative of a deepening and accelerating crisis, but the above selection gets the point as such across, so I'm not going to list all the data here. However, if readers are interested in all the horrid details, here are a few links where more information can be obtained: Haver Analytics (link unfortunately broken on june 28th 2010) and the Institute of Supply Management are both recommended sources of economic data and charts.

The extensive global division of labor, record global trade and capital flows, just-in-time inventory management and instant communication have seemingly conspired to instantly transmit an economic shock wave across the world. Note however that the difference to economic downturns of the past is only in the speed of transmission – the truly large busts have always gone global, only the lead and lag times may have been slightly different.

By now the fact that the yearly decline of the S&P 500 index has at one point in November been the worst ever seems rather normal, especially as the biggest part of the decline happened concurrently with the sharpest deterioration in economic activity (the stock market is not a leading indicator of anything – it has been a coincident and sometimes lagging economic indicator since at least 1998).


'Reflation' is a dud so far

Meanwhile the efforts of officialdom to 'reflate' are going absolutely nowhere. While the Federal Reserve has expanded base money at its fastest rate since the early 1930's, the broad money measure MZM (money of zero maturity) has remained static since March of 2008. Merrill Lynch constructs a measure it calls 'money outside banks', by simply deducting base money from MZM – this is another way of illustrating that banks are taking all the 'free' money they get from the Fed and the treasury and have decided to simply hoard it.



Merrill Lynch's "money outside of banks" measure, deducting base money from MZM – click on chart for larger image.



This is not only due to the fact that bank lending standards have tightened considerably since the beginning of the year (as recent PMI surveys reveal, nearly half of the survey respondents reportedly had trouble obtaining financing), but there is now also a dearth of willing and able borrowers – not counting desperate borrowers, many of whom fail to get credit precisely because of tighter credit standards.


A brief excursion into history – the monumental failures of the Hoover administration

The current situation is so far very much analogous to 1930-1932, years in which the Federal Reserve pumped up base money to an unheard of extent, increasing its balance sheet more than five-fold (!) over 36 months. It is important to keep this in mind, because the falsehood that the 1930's depression was so bad 'because the Fed failed to pump' keeps being widely accepted and bandied about. It is simply untrue.

In fact, one would do well to remember that when the 1930's depression started, absolutely no-one expected the downturn to turn into such a catastrophic economic wipe-out.

The general consensus was that:

1. the still relatively new-fangled Federal Reserve would be able to avert a deep economic downturn due to its 'flexible currency' and

2. that Hoover's new deal type policies would do the same. Hoovers 'new deal'? Yes, you read that right. All the policies that were later christened the 'New Deal' under the leftist FDR were initiated by the allegedly conservative Hoover.

Hoover was one of the first big believers in government interference in the economy who made it to the presidency. He was appointed secretary of commerce in the Republican Harding administration – Hoover had jumped to the Republican party from the Democrats in 1920, as he felt the Republicans would win.

He initially put himself forward as a presidential candidate, but failed in the primaries, and then half-heartedly endorsed Harding. Note in this context that both former navy secretary F.D. Roosevelt and W.W.1 president Woodrow Wilson actually had envisioned Hoover as a potential Democratic presidential candidate, but he jumped ship on account of his well-developed political instincts and an equally well-developed opportunism.

It seems likely that a combination of factors led to Hoover's appointment to the secretary of commerce post by president Harding in 1921 (a post which he kept under Coolidge). On the one hand, the Republican party's left wing wanted to see him in a cabinet post, and for another, Harding had to reward him for his support. Reportedly, Harding actually detested Hoover, who struck him as the very control freak he actually was.

The originally rather nondescript post of secretary of commerce soon became elevated by Hoover's numerous attempts to interfere in the economy. Hoover became known as 'the secretary of commerce and under-secretary of everything else' in Washington. Commerce appropriated responsibilities belonging to other cabinet departments when Hoover thought them 'neglected'.

However, the 'Hoover danger' was kept in check under Harding, who refused to bow to Hoover's demands during the 1921 recession. Harding was the last US president to endorse a 'laissez-faire' approach toward recession, a commendable attitude that had characterized policy under his 19th century predecessors as well.

Therefore, Hoover's proposal to initiate public works programs and keep wage rates artificially high was not followed in the 1921 recession, which helped keep the downturn mercifully brief. To be sure, the 1921 downturn was scary. The rest of Harding's cabinet however distrusted Hoover's ideas, and they turned out to be correct – the economy soon recovered of its own accord. Luckily Hoover did not get the chance to make things worse.

He did get the chance eight years later, when he began to preside over the first three years of the Great Depression. Similar to the often repeated falsehood of the Fed's 'passivity' in the face of the downturn, Hoover is nowadays often described as a paragon of free market policies, whose inaction was responsible for the giant economic bust. This is however merely statist propaganda designed to obscure the facts – spread by revisionist left-leaning historians.

Let's hear Hoover himself on the topic (from his memoirs):

“…the primary question at once arose as to whether the President and the Federal government should undertake to investigate and remedy the evils … No President before had ever believed that there was a governmental responsibility in such cases. No matter what the urging on previous occasions, Presidents steadfastly had maintained that the Federal government was apart from such eruptions . . . therefore, we had to pioneer a new field.”                                                                                   

In April of 1930, as the stock market hit its post crash recovery highs, Hoover was generally hailed as having averted the depression. This was ascribed to his decisive actions in keeping wage rates high, initiating public work programs and farm supports. He put pressure on the Federal Reserve to inflate, which initially met with some resistance from then governor of the board Roy Young. Young however relented, and later decided to resign in August of 1930. He was replaced by a more enthusiastic inflationist, Eugene Meyer.

In April of 1930, a round of back-patting by the interventionists, and glowingly optimistic forecasts of the imminent restoration of prosperity ensued – roughly similar to what we have seen in the months following the Bear Stearns rescue as it were, which was likewise marked by enthusiastic commentary in the press concerning the Federal Reserve's and the government's magical stimulus powers. See some of those comments at the Fundmastery Blog, The New York Times, the Times Online, and CNN Money. Meyer really pushed the pedal to the metal, as the saying goes, and began to boost the Fed's securities holdings to an unprecedented extent, while slashing interest rates to 2% by the end of 1930.

By late 1930, the glow had however dimmed. Hoover, always a supporter of higher tariffs (one of his first actions as president was to hold a conference on tariffs – the conference was mainly concerned with how much to raise them in order to 'help' farmers), signed the Smoot-Hawley Tariff Act against the advice of almost every economist in the nation in mid 1930.

This piece of legislation abruptly aborted the brief stock market recovery – in a wave of panic selling, the market declined back to the 1929 crash low within a few weeks. Nevertheless, Hoover felt the time for self-congratulation had come by October of 1930 (shortly before the stock market broke to even lower levels):

“I determined that it was my duty, even without precedent, to call upon the business of the country for coordinated and constructive action to resist the forces of disintegration. The business community, the bankers, labor, and the government have cooperated in wider spread measures of mitigation than have ever been attempted before. Our bankers and the reserve system have carried the country through the credit . . . storm without impairment. Our leading business concerns have sustained wages, have distributed employment, have expedited heavy construction. The Government has expanded public works, assisted in credit to agriculture, and has restricted immigration. These measures have maintained a higher degree of consumption than would otherwise have been the case. They have thus prevented a large measure of unemployment. . . . Our present experience in relief should form the basis of even more amplified plans in the future. “

Does this sound like a proponent of 'laissez-faire' to anyone? I didn't think so.

Hoover's method was to get big business to 'co-operate' with his plans, by threatening to make his plans compulsory via legislation. Also, there was a curious swing toward leftist policies in big business circles themselves in the early 30's. The natural enemies of central economic planning became curiously enamored of such socialist ideas (see the 'Swope plan' hatched by the then CEO of General Electric, which proposed a fascist cartelization of US industry, and was enthusiastically supported by the chamber of commerce).

1931 turned into a catastrophic year, with all indicators of economic activity plunging further. This spurred even more interventionism on both the administration's and the Federal Reserve's part. Note that the money supply actually contracted in spite of the Federal Reserve studiously blowing up monetary reserves under its control.

There were several reasons for this. For one thing, the public – rightly – mistrusted the banking system, and began to withdraw deposits, converting them to cash. Cash in circulation accordingly actually rose significantly, but bank reserves not under the Fed's control declined still faster than the Fed could pump – as bankers themselves had ceased to trust each other (this sounds vaguely familiar, does it not?), and feared bank runs by depositors. Naturally the fractionally reserved banks all knew that none of them could withstand such a run, and so eyed each other with distrust.

Note in this context the following ominous recent chart:



Currency in circulation has suddenly begun to rise sharply from mid 2008 – the same happened in 1931-1932, as the public, increasingly wary of the banks, started to convert deposits into cash – click on chart for larger image.



Furthermore, the banks saw no reason to extend new credit or buy securities. They rightly feared that such lending would expose them to more default risk, and they wanted to reassure rather than frighten their depositors. One of the decisive factors in this were the Fed's and the administration's attempts to prevent a liquidation of unsound credit by all means.

Needless to say, what the modern-day Federal Reserve is doing today amounts to exactly the same – by taking impaired mortgage securities off the banks books, it likewise prevents the liquidation of unsound credit. For reasons no-one has as of yet deigned to explain, this is somehow supposed to work better nowadays than it did in the 1930's.

Hoover forced the banks (with his usual 'co-operate or i'll legislate' threat) to agree to forming the NCC (National Credit Corporation), whose purpose it was to have the strong banks shore up the weak ones (sound familiar? It should).

The Banks contributed $500m. in capital, and the NCC could borrow up to $1bn. from the Federal Reserve (then enormous amounts). He then hatched the plan to start a state-owned lending agency, the Reconstruction Finance Corporation (RFC), that was to lend to needy banks and businesses, and was intended to become the successor of the NCC. Hoover also leaned on mortgage lenders to delay foreclosures.

His late 1931 plans – to be enacted in 1932 – also included the formation of the Federal Home Loan Bank System, that would be able to discount mortgages and would be backstopped by the government and the Fed, and a vast expansion of the already vast public works program.

A note about the RFC: it was decided that it should be kept secret which organizations and banks received RFC loans, in order to 'avoid a weakening of public confidence' in such firms or banks (not surprisingly, the stench of corruption soon enveloped the RFC). This is analogous to the Bernanke Fed refusing to disclose the precise nature of the mortgage assets it has bought from the banks – in spite of the fact that the tax payers are the involuntary owners of these assets, they are not to know what is being done with their money.

Interestingly, in 1931 the Fed provided large lines of credit to foreign governments as the crisis became acute in Europe as well (the UK and Germany were large recipients of such aid, and Austria and Hungary received somewhat smaller amounts)– shoring up their unsound credit positions as well ('unlimited swap lines' to foreign central banks anyone?).

As classical economists later argued, this contributed to growing mistrust in the dollar, and a consequent outflow of gold from the US. Since European governments, with Britain in the forefront, abandoned the gold exchange standard (not a true gold standard anymore), it was feared that the US may not be far behind. In late 1931, the Fed briefly hiked rates to reverse this outflow of gold, but this policy reversal didn't last long.

In the final quarter of 1931, the money stock collapsed by $4 billion in spite of the Federal Reserve leaning against the wind with large reserves increases, as cash in circulation exploded by $400 million – the public kept withdrawing deposits from the banks as confidence plummeted.

From early 1932 onward, the Fed continued with a massively inflationary policy, forcing interest rates down and expanding reserves under its control by large amounts. This further reduced the incentive for banks to actually lend out money – since the risks were high, they would have at the very least needed high interest rates to compensate for those risks, but the Fed created the exact opposite rate environment.

Furthermore, the Fed was still unable to prevent a fall in the money supply, although one would have normally expected its actions to lead to a large increase of same.

The banks and the public both kept the 'monetary transmission mechanism' perfectly broken. Cash in circulation continued to increase sharply, and reserves not under the Fed's control continued to fall faster than it could expand the ones it did control. Hoover constantly railed against bankers' unwillingness to lend – specifically, he complained that his version of the TARP, the RFC (which eventually grew to 8 times its original size!), bolstered bank capital, but banks would still not inflate credit! Does this not also sound familiar? Barney Franks, actually most of Congress, is making exactly the same complaint these days.

It is worthy of note that under Hoover, government's share of the economy grew mightily, as Hoover produced the by far largest peace-time deficit the US had ever experienced up to that point (this is to say, not only in absolute but also relative terms compared to GDP). This alone should disarm anyone who pretends that Hoover favored a free market approach – not only did government revenue dwindle, but expenditures shot up in unprecedented fashion. In the 1932 presidential campaign none other than Franklin D. Roosevelt accused Hoover of being an 'unconscionable spendthrift'(!), while his running mate, John Garner accused Hoover of 'leading the country down the path of socialism'. They were of course correct, but it clearly was a case of the kettle calling the pot black.

Hoover's follies didn't end there.

Faced with a growing deficit, he unwisely concluded that the time for raising taxes had come. Obama-like, he thought it was a good idea to soak the rich, an idea FDR later enthusiastically expanded upon. Conservative, 'free market' Hoover raised the normal tax rate from a range of 1-5% to 4-8% and the top marginal tax rate from 25 to 63%. He also introduced a sales tax on a large number of products and services (including postal rates), raised the corporate tax rate by 1%, doubled the estate tax, restored the gift tax (at 33%) and eliminated a range of exemptions and tax credits.

Then he pushed the New York Stock Exchange into restricting short selling by February 1932 – a witch hunt was started in the form of a Senate investigation of the exchange and various 'sinister pools of bear raiders' who allegedly 'forced securities below their true value' (as Hoover himself put it). Does this also sound familiar? It should. This is precisely the argument used by the SEC chairman Cox when he restricted short selling of financial stocks just prior to the October market crash.

Will it surprise you to learn that after Hoover had successfully bullied the exchange to outlaw short-selling that the DJIA suffered its biggest downturn of the entire 1929-1932 bear market? The market declined by 65% from the enactment of the restriction to its eventual low in the summer of 1932. Maybe SEC chairman Cox should have taken a brief look at the effects of this historical short selling ban before engaging in the same folly.


Why Hoover's modern-day heirs will fail

The above historical information is largely sourced from Murray Rothbard's book 'America's Great Depression', which I encourage everyone to read. It can be downloaded for free here (pdf).

The purpose of recounting the historical depression episode is to point out the many parallels that already exist between the interventions government enacted back then and those it is enacting now. Specifically, the artificial preservation of unsound credit and malinvested capital, coupled with grand plans to 'invest in infrastructure' (public works) and enact other types of 'stimulus spending' are eerily similar.

The things the Bernanke Fed and the treasury are doing are very similar to the things the Meyer-led Fed and the RFC engaged in – and it is encountering precisely the same problems. Banks are unwilling to lend, and borrowers are unwilling or unable to borrow, so a theoretically highly inflationary expansion of the money base and the Fed's balance sheet has so far failed to entice any broader inflationary effects.

Meanwhile the activities of the GSEs Fannie Mae and Freddie Mac under 'conservatorship', whereby they have begun to once again expand their balance sheets in spite of the fact that this is obviously economically unsound (they keep producing record losses for one thing) and various government plans to prevent foreclosures and 'persuade' creditors to weaken their claims by threatening them with the requisite legislation, are likewise reminiscent of the same approaches during Hoover's administration. Hoover's RFC is a close cousin to Paulson's TARP – it did essentially the same thing, namely provide government money to weak banks.

Obama meanwhile proposes to actually raise the minimum wage – which is reminiscent of Hoover's policy of preventing wage rates from falling in alignment with other prices. This policy practically guarantees rising unemployment.

The 1920's boom that led to the sharp increase in malinvestment that eventually produced the bust, was a boom during which 'stable prices' were a central Fed policy, just as they have been throughout the 1990's and the 2000's. Thus, a large increase in economic productivity allowed the Fed to inflate the money supply willy-nilly, which prevented the fall in the general price level that would have occurred absent such inflation.

The policy of 'stable prices' was in reality a policy of inflation, and allowed the other effects of inflation, chiefly the amassing of malinvestments and the creation of artificial, non-wealth generating activities, to proliferate. Furthermore, while the general price level appeared stable both in the 1920's boom under Benjamin Strong and the modern day boom mostly under Alan Greenspan, securities and real estate prices increased sharply, encouraging the credit boom further (whereby rising collateral values formed the basis for more credit creation).

Another feature of both booms was that consumer credit exploded, with consumers lulled into complacency by the seeming 'soundness' of their balance sheets. The ensuing consumption boom is precisely what damaged the economy's production structure in both cases, by misleading business-men about sustainable levels of demand. The expansion in credit increasingly encouraged exchanges of 'something' (real resources and goods) for 'nothing' (money out of thin air, created by the Fed and the fractionally reserved banking system), depleting the pool of real funding while the respective booms proceeded.

One thing that is different today is that the Fed has become even more 'flexible', its currency even more 'elastic'. Hoover never intended to abandon the gold standard – this was a step too far even for him. The modern-day Fed has no such restraints to worry about. Note in this context that what we have heard from the horse's mouth – Bernanke himself – regarding possible Fed actions to 'combat deflation' is absolutely hair-raising stuff.

Over half of these suggestions have already been implemented (the following quotes are from his famous speech “Deflation: Making Sure "It" Doesn't Happen Here”) :

“The Fed must expand the scale of its asset purchases or, possibly, expand the menu of assets that it buys.”

“The Fed could find other ways of injecting money into the system–for example, by making low-interest-rate loans to banks.”

He notes the Fed could “offer fixed-term loans to banks at low or zero interest, with a wide range of private assets (including, among others, corporate bonds, commercial paper, bank loans, and mortgages) deemed eligible as collateral.”

“The government could…acquire existing real or financial assets.”

“If the Treasury issued debt to purchase private assets and the Fed then purchased an equal amount of Treasury debt with newly created money, the whole operation would be the economic equivalent of direct open-market operations in private assets.”

“Lowering rates further out along the Treasury term structure” either by “holding the overnight rate at zero for some specified period” or by using a “more direct method, which I [Bernanke] personally prefer” would be to announce “explicit ceilings for yields on longer-maturity Treasury debt.”

In other words, the Fed must inflate at all costs, precisely when the economy needs the opposite. Naturally it makes no sense whatsoever to attempt to keep malinvested capital in place and create additional malinvestments on top of it.

There is a natural limitation to all the governmental efforts to 'reflate' in the form of the economy's subsistence fund. Its size is finite, and it has been weakened by the previous large credit expansion. Remember that 'money out of thin air' allows people and businesses to bid for resources and goods without first producing any resources themselves. This by necessity must weaken those sectors of the economy that actually produce wealth, since they have to compete for these resources.

Furthermore, what the government is doing is to merely redistribute existing resources when it enacts 'economic stimulus' packages and 'public works' programs. It is irrelevant how worthy some bureaucrat with incomplete information deems a certain infrastructure spending project to be – the fact remains that the resources employed in this state-directed spending must be removed from where they are employed prior to such state-directed spending.

The government has three possibilities to raise funds to engage in its spending: it can tax, it can borrow, and/or it can print money.

The former two amount to a straightforward redirection of existing resources from a market-based allocation process to a government-directed one. The only way this could possibly be beneficial would be if we actually believed that government directed resource allocation process is to be preferred over the market-directed one, because it has been proven beyond the shadow of doubt that government bureaucrats are better at this than the market.

If one believes that, it would be time to cast a quick glance toward North Korea to see what happens when government is the only agency engaged in resource allocation (It is no coincidence that a complete takeover of the economy by government is only possible in conjunction with a terrible tyranny).

The third possibility, namely a policy of inflation, i.e. of printing money out of thin air (Bernanke's department), can obviously only lead to more of the same that has actually brought us to this juncture: a misallocation of resources and consumption of scarce capital as the pool of real funding sustains further damage.

It is to be expected that the policy of inflation, which is now being openly pursued (the Fed admits that its mooted, $800bn. purchase of MBS and ABS, which has begun last week, will 'add to bank reserve assets' – in other words it amounts to outright monetization, euphemistically known as 'quantitative easing'), will continue to flounder for a good while as capital-impaired banks refuse to lend money in view of the heightened risks of doing so.

At the same time, the massive 'guarantees' (such guarantees are only worth something as long as not too many people call on their fulfillment at once) provided by the FDIC have made the prospect of bank runs a fairly remote one, so an important check on banker recklessness does effectively not exist, or is severely weakened.

In addition, it can already be gleaned from Bernanke's comments that a much greater monetization effort (of 'private assets' which the treasury buys via the Fed monetizing treasury debt) would eventually ensue should the current efforts continue to fail in igniting 're'-inflation.

So the possibility that wider inflationary effects eventually become visible in the data (via growth in broader money supply measures re-accelerating) can not be ruled out. While the traditional modus operandi, whereby the Fed 'transmits' its monetary pumping via the commercial banks lending and creating new deposits, that then are re-lent, ad infinitum (the famous 'money multiplier') may continue to fail just as it has in the 1930's, the non-traditional methods may well meet with 'success' (if you define success as doing more damage to the economy's production structure, that is). This largely depends on the central bank's determination.

Wealth can of course not be increased by one iota through such efforts – if and when more money units circulate, the existing money units become worth less, and the many negative consequences of an inflationary policy manifest themselves.

The economic bust, and the – current – deflationary manifestations of this bust, are necessary to liquidate and redirect malinvested capital. Keeping such malinvested capital on artificial life support leads as we have seen to nothing but unintended consequences. This is why the massive interventions already implemented and those yet to come are doomed to fail and actually are a very good reason to remain pessimistic about the future.

Contrary to what Bernanke claims, it is not the sudden frugality of consumers that has 'created the recession' – it is the damage done to the economy's production structure that is at fault, and this has been a consequence of previous policies that furthered too much (unbacked) consumption.

It makes no sense for government to try to avert the liquidation of unsound credit positions. This will only prolong the misery, as banks continue to have every reason in the world to distrust both each other as well as the economy's capacity to right itself.

Finally, the fall in prices that has recently occurred, is actually a small reason for hope, as Lew Rockwell points out here. There is no good reason to try to prevent it, as is claimed by the government.



Charts by : Federal reserve, Merryll Lynch




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