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The Recurring Crisis

Stephen Davies

Recently the governor of the Bank of England announced that the “nice” times had come to an end. (In the Bank’s lexicon, NICE = “Non-Inflationary Constant Expansion”). This news will not come as any shock to the many Americans who have had their homes repossessed recently, but it does appear to have startled many of the scribblers who make their living from the financial pages on my side of the Pond.

One of the two most striking features of the current financial contretemps is the way it has seemingly come as a complete surprise to most financial commentators and economists. (The other is the way that financiers and bankers who have spent the last few years presenting themselves as buccaneering entrepreneurs have suddenly discovered a fondness for taxpayer bailouts.)

As recently as a year ago, most commentators in the financial press were convinced there was no real prospect of a major correction to the real-estate market, much less a serious financial crisis. There were dissenting Jeremiahs who warned that things could not go on as they had been, but they were in the minority. (They included the most successful investor in America, Warren Buffett.)

With no sense of satisfaction I report that I was, in my own small way, one of the Jeremiahs. I did not foresee all that has happened—neither did anybody else—but the broad outline was clear. Why did the majority miss it? The answer is a combination of common sense and a historical perspective informed by a certain approach to economics.

Trends and the Popular Mind

The first is easy enough to explain. A recurring feature of the popular mind is the belief that whatever trend is dominant at the moment can only continue indefinitely. Thus if the prices of houses and other assets are rising and have been rising for some time, then they must continue to do so indefinitely into the future. Talented and intelligent people then come up with all sorts of elaborate explanations of why this must be so. These are little more than elaborate rationalizations of assumptions. The contrary, common-sense view was captured by the chairman of Richard Nixon’s Council of Economic Advisers, Herbert Stein: “If something cannot go on forever, it will stop.”

However, common-sense observations and instinct do not help us understand precisely what has happened to the U.S. financial system and economy over the last decade, or why it happened and why it has now come to a messy end. The thing to grasp is that this kind of phenomenon has happened before. The current “credit crunch” is only the most recent of several such financial crises going back to the mid-nineteenth century or even the 1820s. Besides the events of 1929–1932, there were severe financial crises (“panics”) in 1873, 1893, and 1907. There was nearly a similar panic in 1997, and in many ways it is the response of the authorities to that year’s events which produced the situation we face today.

Although the details of the crises are distinctive, they all have something in common: they were the dramatic system-wide effects of manipulation of the money supply. The distinctive details are produced by the way monetary policy interacts with the most recent innovations in the financial markets.

Because of errors of public policy, the government’s monopoly central bank increased the money supply above the underlying level of actual economic growth. This can lead to a general rise in money prices (inflation), but that is not inevitable. Frequently a rise in the amount of money needed to buy consumer goods is concealed by a rise in productive efficiency, which reduces production costs so much that money prices still decline. However, the rise in the supply of money and credit leads in all cases to a rise in the money prices of assets and investment goods, such as securities, stocks, land, real estate, and even such things as antiques and fine wine.

This sparks off a speculative spiral in which people invest in capital goods not because of the anticipated return or because of their utility (as in the case of houses), but because they expect the money value of the good to rise. To return to Herbert Stein, this cannot go on forever, and eventually the underlying expansion of the money supply that drives the whole process will stop. (In fact it doesn’t have to actually stop; it is only necessary for the anticipated rate of increase to decline.)

Problems Are Exacerbated by Monetary Disorder

At this point two things become apparent. One is that a lot of investments are unsound and will never justify themselves. The other is that many people are left holding assets that are worth less than what they paid for them. The result is a period of economic pain in which the malinvestment has to be liquidated.

Paradoxically, the speculative spiral, or bubble, is actually amplified by open and competitive investment markets and tends to be most pronounced in newly developing sectors or with regard to newly created investment vehicles (railroad stocks and bonds in 1893, derivatives in the current events). The problem is that the more efficient and open a market is, the better it will respond to market signals as expressed in prices. If those signals are systematically distorted by an underlying monetary disorder, the response will amplify that disorder. The more efficient the market, the greater that effect. Because this bubble tends to be most pronounced in areas that have seen financial innovation, each particular panic has an element that is novel and typically completely unforeseeable.

Looked at in this way and with the benefit of historical perspective, the events of the last decade become clear. In response to the crisis of 1997 (brought about in turn by the policies of governments in various parts of the world), the world’s monetary authorities (above all, the Fed) expanded the money supply. This led to an asset bubble in shares, particularly those in cutting-edge hi-tech sectors. The bubble burst in 2001. The Fed, along with other central banks, then increased the supply of money and credit even further to avoid the painful reckoning. However, by trying to avert a recession in 2001–03 they precipitated an even-more-severe one now. The continued expansion simply led to another asset bubble, this time mainly in real estate, which has also burst. In this case the novel element is complex financial instruments based not on prices set by markets but rather elaborate mathematical models—which we now realize are useless precisely when you need them most: during a sudden shock.

A common response to these events is to blame the inherent qualities of financial markets. Certainly the response of people within those markets to adversity does not help their cause. However, the underlying active agency behind recurring crises of this kind is the government’s money monopoly. As long as its policy errors can have large-scale disastrous consequences, three sentences should fill you with fear: “The price of X cannot fall”; “We have managed to get rid of the business cycle”; and “This time it’s different.”

It can. We have not. And it isn’t.

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