The View From 1776

Popular mythology, continually preached by liberal-progressives, is that the 1929 and 2008 crashes were caused by wild speculation in the financial markets.  In fact, the underlying cause in both cases was the same: excessive expansion of the money supply by the Federal Reserve.

In 1929 it was said to have been the product of insider manipulation and the public’s speculative mania.  The real cause was the Fed’s excessively easy money policy to support rebuilding of European economies after World War I’s devastation.  Responding to the flood of money and lower interest rates, farmers and manufacturers went into debt to expand their output for export to Europe.  European banks borrowed heavily in New York to pay for those exports.  When our high tariffs impeded Europe’s ability to sell goods to us to repay their loans, the economy began to tank, leading to the 1929 crash.

In 2008, liberal-progressives similarly attribute the financial collapse to banking deregulation that supposedly induced speculation, greed and criminality of lenders and investment bankers, a view that is shared by the great majority of the public.

For both the 1929 and 2008 crashes, the generally accepted remedy has been strict, even punitive, additional regulation of banks and financial markets.  But this is analogous to dealing with building collapses by regulating paint jobs and exterior trim. 

Students in the post-World War II 1950s and 60s were taught that President Franklin Roosevelt’s Keynesian economic policies adopted under the New Deal would prevent future depressions and that financial market aberrations had been prevented by creation of the Securities and Exchange Commission and the Federal Deposit Insurance Corporation.

Experience has revealed this to be malarkey.  Today’s disaster was preceded by the 1990s massive dot-com boom and bust, and by the 1980s collapse of the savings and loans caused by the run-away inflation induced by President Johnson’s Great Society welfare-state entitlements spending.  The same recurrent pattern can be observed all the way back to the end of World War II.

Each time, new sets of regulations were imposed, but the boom-and-bust phenomenon keeps coming back, always in a slightly different manifestation not anticipated by the latest set of regulations.

As I wrote in Liberals’ Wall Street Pirouette (March 22, 2008):

Human beings, from the wage-earning homeowner to the Wall Street tycoon, will always find ways to use huge amounts of money when the economy is awash in liquidity created by the Fed’s deliberate policies (what Fed chairman Bernanke laughably called, a few months ago, “a worldwide glut of savings"). 

The Fed’s rampant expansion of the money supply gave false signals to the entire economy, leading individuals to go on a spending binge, buying automobiles, gizmos, and homes on credit... 

Equally damaging has been the misallocation of the economy’s scarce resources induced by inflationary expansion of the money supply.  In the traditional capitalist economy based on savings rather than on credit, without lenders thrusting home mortgages and credit cards into the hands of non-creditworthy borrowers, the huge overproduction of housing would not have occurred.

That credit would not have existed had the Fed not flooded the market with excess money.  The Fed played the role of the man who gives matches to small children and tells them to set the woods afire so that shiny red fire trucks will appear, with wailing sirens and clanging bells. 

In Can Government Fix the Over-Built Housing Market? (March 29, 2008) I wrote:

Bottom line: the crash of the housing industry, the subprime mortgage meltdown, and the securitized debt disintegration that threaten the financial community originated with the Federal Reserve.  In the extended period during the 1990s and into recent times, Fed Chairman Alan Greenspan kept interest rates artificially low by flooding the market with excess money.  Chairman Bernanke, who believes that the Depression was caused by the government’s failure to spend enough, is carrying on that destructive policy.

The Fed’s current emergency actions may temporarily bail out Wall Street, but they will only impede and prolong the workout in the housing industry.  Continuing inflationary expansion of the money supply will keep us at square one, with unqualified buyers who will have no equity in the properties they aim to buy using mortgage loans which their incomes are insufficient to service.

The interpretative problem originates in Keynesian macroeconomics, part of the religious dogma of liberal-progressives.  Keynesians assume that aggregate demand and aggregate supply for the economy as a whole are single “things” that can be reduced to one supply-and-demand graph.  This is an oversimplification that masks a huge complexity of demand and supply factors, along with widely differing time scales of production.

Keynesians’ oversimplification leads them to the assumption that, if aggregate demand is less than aggregate supply, then the government has only to put more fiat dollars into consumers’ hands to increase consumption and to re-energize economic production and employment.

What in fact occurs is that additional artificial-money handouts from the government simply drive up prices, prolonging and aggravating the distress…

Monetary manipulation by the Fed sends misleading signals to the very large part of the economy that is involved in long-cycle production of capital goods.  Excess expansion of the money supply leads capital goods producers to over expand their investments in production capacity to meet an illusionary, credit-based consumer demand.  Additionally, the artificially low, Fed-managed interest rates make investment in capital projects appear to be profitable, though they may be uneconomic at free-market interest rates…

Misunderstanding the nature of the problem, Congressional liberals aim to end recessions by churning out an endless array of government spending programs, and the Fed accommodates them with a flood of money. 

That over-expansion of the money supply and, in the early stages, the artificially low interest rates for loans make developers [home builders] think that consumers have sufficient real savings to buy their products and that the projects will be profitable.  Remember that developers must make multi-year spreadsheet projections of costs and revenues to determine the economic feasibility of a project and to persuade lenders and equity investors to finance it.  And their spreadsheet projections must employ assumptions about interest rates.

The result is commencement of long-term projects that lead to oversupply of finished goods several years later.

Whenever we experience economic shocks such as the current subprime meltdown, the natural, though misguided, tendency is to search for a villain, somebody or some institution whose malfeasance caused the problem.

In fact, such shocks are inherent in the Fed’s creation of excess money supply and artificially low interest rates.  Once the dollar begins falling in foreign exchange markets and inflation worries begin to take hold, the Fed has to slow down creation of money in an effort to keep inflation within its policy limits and to fix interest rates at what its bureaucrats have selected as the appropriate level of market interest rates.  When the Fed begins to change course, the game is up. 

Deals that appeared several years earlier to be profitable no longer are when inflation drives up production costs and selling prices.  But the capital goods capacity expansion and finished goods oversupply are already in the pipeline.