Lesson Unlearned

Henry C.K. Liu

October 29, 2009 is the 80^th anniversary of the crash of 1929 that led to the Great Depression. Did the world learn the lesson of 1929?

Milton Friedman identified through exhaustive analysis of historical data the potential role of monetary policy in shaping the course of inflation and business cycles, with the counterfactual conclusion that the Great Depression of the 1930s could have been avoided with appropriate Fed monetary easing to counteract destructive market forces. Friedman’s counterfactual conjecture, though not provable, has been accepted by central bankers as monetary magic to rid capitalism of the curse of business cycles. It underpins the Greenspan-led Fed’s “when in doubt, ease” approach all through his 18-year-long tenure which led to serial debt bubbles, each one biggest the previous one. The final one burst in 2007.

Most macroeconomists, including current Fed Chairman Ben Bernanke, subscribe to the debt-deflation view of the Great Depression in which the collateral used to secure loans (or as in the current situation, the assets backing derivative instruments) will eventually decrease in value from excessive debt, creating losses to borrowers, lenders and investors, leading to the need to restructure the loan terms or even loan recalls. When that happens, macroeconomists believe that government intervention to supply liquidity is both necessary and effective in keeping markets from failing.

The term debt-deflation was coined by Irving Fisher in 1933 to describe the way debt and deflation can destabilize each other. Destabilizing arises because the relation runs both ways: deflation causes financial distress for debt, and financially distressed debt in turn exacerbates deflation. This debt-deflation cycle is highly toxic in a debt-infested economy. The only way to prevent it is to not allow liquidity to flow into debt.

Friedman held out the false hope that central bankers could negate debt-deflation instability with wholesale liquidity injections.

Hyman Minsky in The Financial-Instability Hypothesis: Capitalist Processes and the Behavior of the Economy (1982) elaborated the debt-deflation concept to incorporate its effect on the asset market. He recognized that distress selling reduces asset prices, causing losses to agents with maturing debts. This reinforces more distress selling and reduces consumption and investment spending which deepen deflation. This has come to be known as the Minsky Moment.

Friedman’s counterfactual conclusions obscured the lesson the world could have learned from the crash of 1929 and condemned the world to face another disaster again 80 years later.

In all, four false counterfactual conclusions on the 1929 crash accepted as economic truths have since given birth to an economics of instability:

False: Aggressive monetary easing measures can save the economy from business cycle recessions. This conclusion led central bank monetarism to finance unsustainable debt bubbles. And only if the Fed had intervened earlier and firmly in 1929, it could have prevented the depression (Friedman). Bernanke is discovering in 2007 that this is not true.

False: World trade must be maintained to keep depression at bay.

Fact: Under predatory terms of global trade based on currency hegemony, fueled by regulatory and wage arbitrage, world trade is the cause of global imbalance. Global free trade has been the prime cause for domestic unemployment. As global free trade grew dramatically, unemployment and underemployment rose in both the US and Chinese economies.

Solution: New terms of trade must be introduced to reverse the adverse impact of international trade on employment, wages and domestic development. Restore international trade to augment rather than preempt domestic development.

False: Only capital can create employment.

Fact: Under conditions of overcapacity, only full employment with high wages can create savings/capital. Say’s law (supply creates its one demand) holds only with full employment. Without global full employment, comparative advantage in free trade is merely Say’s law internationalized.

False: Comparative advantage in free trade is a win-win formula for both trading partners.

Fact: Comparative advantage has a fatal cost to the partner who forgoes technological development in exchange for economic efficiency in trade. Ricardo, in analyzing trade between Britain and Portugal, failed to point out that by focusing on producing cloth, which required mechanization, British gained a mechanized economy that gave it a modern navy to take over the Portuguese empire. Because Portugal elected to produce wine in exchange for British cloth, it remained a technologically underdeveloped agricultural economy and in time ceased to be a major power.

Solution: In a world order of sovereign states, weak national economies must seek redress through economic nationalism.

www.henryckliu.com - 29.10.09