In short the 1920s were an era of world-wide credit expansion. Its most spectacular phase was the large- scale financing of inflated security and real estate values, especially in the United States. Such overcapitalised values were not reflected in the price level indices, which has generated confusion. Both Lauchlin Currie and Friedman and Schwartz have insisted, as have many others, that there was no inflation in the 1920s, since 'prices' did not rise.
- Melchior Palyi, The Twilight of Gold, 1914-1936, 1972
Since Benjamin Bernanke's nomination by President Bush to succeed Alan Greenspan at the helm of the Federal Reserve, it has been widely reported that Bernanke had fixed his earlier professional career as a professor of economics upon the study of the cause or causes of the 1930s Great Depression, with the intent to make sure that this will never happen again.
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At a conference in 2002 honouring Milton Friedman's 90th birthday, he expressed contrition on behalf of the Federal Reserve: 'Regarding the Great Depression, you are right, we [The Fed] did it. We are very sorry. But thanks to you, we won't do it again.'
Wondering about Mr Bernanke's academic research, we took a closer look at his earlier writings and contemporary speeches. We learned that he did 'groundbreaking research on how declining asset prices and weakened banks can choke off new lending and economic growth, and how the mistakes of the Federal Reserve compounded the catastrophe.'
America's Great Depression was by far the greatest economic and financial disaster in history. Yet it strikes us that the discussion in the United States has been stuck in the assertion that the Fed's failure to ease its reins fast enough was key to the savage asset and price deflation that followed during the 1930s.
The question of what may have gone wrong during the prior boom to cause the Depression has always been discarded as beside the point, with the argument that the extraordinary price stability prevailing in the 1920s represented conclusive evidence of the absence of any inflationary influences.
For most American economists, the verdict of Milton Friedman and A.J.
Schwartz at the end of their Monetary History of the United States, 1867-1960, published in 1963, about the causes of the Great Depression, is virtual dogma. And so it is for Mr Bernanke. To quote Friedman:
'The stock market boom and the afterglow of concern with World War I inflation have led to a widespread belief that the 1920s were a period of inflation and that the collapse from 1929-1933 was a reaction to that.
'In fact, the 1920s were, if anything, a time of relative deflation: From 1923-1929 - to compare peak years of business cycles and to avoid distortions from cyclical influences - wholesale prices fell at the rate of 1% per year and the stock of money rose at the annual rate of 4% per year, which is roughly the rate required to match expansion of output. The business cycle expansion from 1927-1929 was the first since 1881-1893 during which wholesale prices fell, even if only a trifle, and there has been none since.
'The monetary collapse from 1929-1933 was not an inevitable consequence of what had gone on before. It was the result of the policies followed during those years. As already noted, alternative policies that could have halted the monetary debacle were available throughout those years. Though the Federal Reserve proclaimed that it was following an easy monetary policy, in fact, it followed an exceedingly tight monetary policy.'
The 1920s were, indeed, a period of extraordinary price stability. In particular, under the influence of Milton Friedman, it became axiomatic for American policymakers and economists that the Depression must consequently have had its causes in the policies pursued after the stock market crash. One of the consequences of this generally accepted verdict has been a total lack of interest to probe more deeply into the intricacies of the boom phase. As a result, knowledge about eventual abnormalities during this phase is generally abysmal, even among leading American economists.
Actually, the Fed moved quite fast in light of earlier experience, slashing its discount rate from 6% to 2.5% within one year. The first steep fall of stock prices lasted little more than two weeks, from Oct. 24 to Nov. 13, 1929, from where it sharply recovered until April 1930.
After a pretty stable first half of 1930, during which stock prices rallied strongly, the economy suddenly slumped in the second half, even though the broad money supply had barely budged. To quote Joseph Schumpeter: 'Business operations contracted in the midst of a plentiful supply of 'money.''
With the euphoria about a 'New Era' for the US economy still virulent after the stock market crash, a quick recovery was generally expected.
What strikingly differentiated this downturn from all forerunners was the sudden, sharp slump in consumer spending. Yet it was taken for granted that the Fed's rapid rate cuts would usher in economic revival.
A truly dramatic change in economic activity, and also in expectations, only began with the banking crisis of November-December 1930, acting to reduce the money supply. Escalating bank failures principally had their reason in declining market values of foreign, corporate and real estate bonds ravaging the banks' capital and lending power. The question is why asset prices fell - because of tight money or due to rising risk premiums as the quality of bonds began to be questioned?
It is the great merit of the proponents of Austrian theory to have uncovered and shown that the borrowing and spending excesses driving a boom may, with or without inflation, exert harmful economic and financial effects other than just a rising inflation rate - actually, more harmful effects.
In the post-war period, recessions in the industrialized countries were sharp and brief until the late 1970s. Limited spending excesses in inventories, business fixed investment, consumer durables and construction were liquidated within barely a year. In the United States, the typical recession for the post-war period has averaged one year, with a decline in real GDP by 2%. As soon as the Fed loosened its shackles, pent-up demand in the areas affected by credit restraint took off again, catapulting the economy to new heights.
Sometime in early 2001, Mr Greenspan expressed the view that the unfolding recession was of the harmless 'garden-variety' type. This used to be the popular label for the short 'cyclical' recessions that had been typical of the whole post-war period.
Actually, the US economy's downturn in 2001 had no relationship or similarity whatsoever to the customary 'garden-variety' cycle. Credit growth, far from slowing down, accelerated as never before. An unprecedented slump in business fixed investment, plunging over the following eight quarters by 14.5%, acted as the single depressant.
But sharp increases of other demand components, propelled by prodigious fiscal and monetary stimuli, soon more than offset the slump in business fixed investment. Government spending increased by 9.2% during the same eight quarters. In the private sector, the Fed- engineered housing bubble boosted residential building (+7.2%) and consumer spending (+6%). The net result was America's shallowest recession, but what followed was the slowest economic recovery in the post-war period.
Could there be a connection between the two?
Why the weakest recovery despite the most prodigious policy stimulus in history? If the economy's downturn was unique in its pattern, so also was the pattern of its upturn.
By the third quarter of 2005, real GDP had grown 14.1% since 2000. It had accrued from disproportionate gains in residential building (+36.5%), consumption (+17.3%) and government spending (+16%). The major adverse counterbalancing forces were sluggish business investment (+5.9%) and soaring imports (+23%).
Over the whole period, real GDP has grown at an annual rate of 2.9%. That is well below the average growth rate of 3.8% for previous post-war business cycles. Outright dramatic is the shortfall in employment and inflation-adjusted income growth. With all the phantom jobs from the 'net birth/death,' private sector jobs are just 1% higher than in December 2000, for which employment for defence spending played a significant role. For comparison, payroll jobs in past cycles have risen about 9% over the same time.
Essentially, this dramatic shortfall in employment implies a corresponding shortfall in income growth. During the three months to November 2005, real disposable incomes of private households exceeded their year-ago level by just 1.36%, as against 3.4% for real GDP.
Mr Greenspan and other Fed members have never made a secret of their systematic efforts to create a panoply of new asset bubbles after the equity bubble popped. Among their policy novelties was the repetitive public assurance to keep their short-term policy rate at a rock-bottom level for as far as the eye can see as incentive for carry trade, particularly for long-term bonds, and as the key condition for inflating asset prices.
Enraptured financial institutions promptly obliged by driving long-term rates and credit spreads to record lows through heavily leveraged carry trade. For the consensus, this represented a highly successful monetary policy that had bowed to no rules.
In hindsight, they hail the many achievements: enormous 'wealth creation' through rising house prices, record- high productivity growth, stable and comparatively strong economic growth and the mildest post-war recession in the wake of the bursting equity bubble in 2001.
It makes an impressive list - only a very incomplete one. It ignores a variety of economic and financial inflictions causing and reflecting extremely unbalanced economic growth. This negative list begins with the savings collapse and the monstrous trade gap, and it continues with the housing bubble and the surge of consumption as a share of GDP. Last but not least, it must be taken into account that this sub-par economic and income growth has involved an unprecedented credit and debt orgy.
By Dr Kurt Richebcher for The Daily Reckoning. You can read more from Dr Richebcher and many others at www.dailyreckoning.co.uk.
Former Fed Chairman Paul Volcker once said: 'Sometimes I think that the job of central bankers is to prove Kurt Richebcher wrong.' A regular contributor to The Wall Street Journal and several other respected financial publications, Dr Richebcher's insightful analysis stems from the Austrian School of economics. France's Le Figaro magazine has done a feature story on him as 'the man who predicted the Asian crisis.'
