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There were astute thinkers during the twenties who believed the economy was being severely distorted from a protracted inflationary period that had commenced during the (first) World War. Although it was not manifesting in consumer prices (because of new technologies, products, overheated investment, etc.), excessive money and Credit were fueling dangerous inflationary Bubbles in asset prices – particularly in real estate and the stock market. Certainly, the great “Austrian” thinkers recognized clearly how Credit and speculative excess had come to grossly distort incomes, corporate profits, relative prices and investment. The underlying structure of both the financial and economic systems was being corrupted.
Importantly, during that fateful period a group of seasoned thinkers (businessmen, policymakers, and economists) believed adamantly that policies endeavoring to sustain the distorted pricing mechanisms and the resulting inflated and maladjusted U.S. economy were both inadvisable and doomed for failure. As such, so-called “liquidation” was a central facet of the unavoidable (post-inflationary boom) adjustment period for the highly distorted financial, labor and product markets. Profligate borrowing, spending, and leveraged speculation would come to their eventual end, requiring reallocation of both financial and real resources. It was only a matter of the degree of excess and the proportional adjustment.
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Recent extraordinary government measures to “back” U.S. finance will likely delay the adjustment process – what I will be referring to as a “depression.” This reprieve, however, comes with a cost. It will ensure significantly greater damage to the core of our monetary system, as well as requiring a more onerous real economy “liquidation.”'
Economic Structure and the "Liquidationist Thesis"By Doug Noland
April 04, 2008
SourceBetween Secretary Paulson’s proposal Monday for financial regulation overhaul; Wednesday’s testimony by Federal Reserve Chairman Bernanke on housing and Bear Stearns before Congress’s Joint Economic Committee; the appearance Thursday by Bernanke, New York Fed President Timothy Geithner, Treasury under-secretary Robert Steel, and SEC Chairman Christopher Cox before the Senate Banking Committee; and the later appearance before the same committee by JPMorgan’s CEO Jamie Dimon and Bear Stearns’ CEO Alan Schwartz – there was ample material this week for an entire book delving into critical financial issues of our day. I’ll attempt a couple pages worth.
From one of Dr. Bernanke reponses: “One of the prevailing theories at the time of the Depression was the so-called ‘liquidationist thesis” – who said basically “let’s let the system return to normal. Let’s liquidate banks; let’s liquidate labor.” This was Andrew Mellon, the Treasury Secretary. It was partly on the basis of that theory that the Federal Reserve stood by and let a third of the banks in the country fail, which created the money supply to drop sharply, and caused prices to fall rather sharply, and led ultimately to the severity of the financial crisis. I think financial instability, which was not addressed by government or anyone else, was a major contributor, both to the depression in the U.S. and abroad. I believe the difference today is that we will address financial issues and try to maintain the integrity and stability of our financial system. We will not let prices fall at 10% a year. We will act as needed to keep the economy growing and stable. So, I think there are some very significant differences between the thirties and today, and we learned a great deal from that episode.” April 2, 2008, before Congress’s Joint Economic Committee.
Not surprisingly, Chairman Bernanke invokes a notable policy error - committed in the heat of an extraordinarily difficult (post-Bubble) early-1930s period - as justification for government measures to sustain today’s U.S. Bubble Economy. Bernanke and the “Friedmanites” just love to pillory Andrew Mellon and the “liquidationists” (and would gladly throw in Hayek and Mises). They avoid (like the plague), however, the much more pertinent policy debate that transpired throughout the Roaring Twenties.
Mr. Mellon was among a group of elder statesman that had become increasingly concerned throughout the decade by the Wall Street speculative boom and its inevitable consequences. The son of a banker, his family’s wealth was nearly lost in the Panic of 1873. Actively involved in banking and business from the age of 17, he had witnessed first hand the consequences of the recurring booms and busts that were the impetus behind the creation of the Federal Reserve in 1913. Blaming Mr. Mellon and the “liquidationists” for the Great Depression – as opposed to the extraordinary financial excesses and failed policies of the Bubble period - does disservice to history as well as sound analysis.
There were astute thinkers during the twenties who believed the economy was being severely distorted from a protracted inflationary period that had commenced during the (first) World War. Although it was not manifesting in consumer prices (because of new technologies, products, overheated investment, etc.), excessive money and Credit were fueling dangerous inflationary Bubbles in asset prices – particularly in real estate and the stock market. Certainly, the great “Austrian” thinkers recognized clearly how Credit and speculative excess had come to grossly distort incomes, corporate profits, relative prices and investment. The underlying structure of both the financial and economic systems was being corrupted.
Importantly, during that fateful period a group of seasoned thinkers (businessmen, policymakers, and economists) believed adamantly that policies endeavoring to sustain the distorted pricing mechanisms and the resulting inflated and maladjusted U.S. economy were both inadvisable and doomed for failure. As such, so-called “liquidation” was a central facet of the unavoidable (post-inflationary boom) adjustment period for the highly distorted financial, labor and product markets. Profligate borrowing, spending, and leveraged speculation would come to their eventual end, requiring reallocation of both financial and real resources. It was only a matter of the degree of excess and the proportional adjustment.
To further inflate an unsustainable boom with additional cheap Credit guaranteed only more problematic financial fragility, economic imbalances and resulting onerous adjustment periods. They were adamantly against the (Benjamin Strong) Federal Reserve’s efforts to actively manage the economy in the late years of the twenties, fearing that to prolong the reckless Wall Street debt and speculation orgy was to invite disaster (the “old timers” had witnessed many!). History proved them absolutely correct, yet Historical Revisionism to varying extents has been determined to disregard, misrepresent, and malign their views and analytical focus. Bernanke’s analytical framework of the causes of the Great Depression is seriously flawed.
Regrettably, efforts by the Federal Reserve and Washington politicians to sustain the U.S. Bubble Economy are doomed to failure. It’s not that they are necessarily the wrong policies. More to the point, the basic premise that our economy is sound and growth sustainable is seriously flawed. We’ve experienced a protracted and historic Credit inflation and it will not be possible to keep asset prices, incomes, corporate cash flows, and spending levitated at current levels. The type and scope of Credit growth required today has become infeasible. Sustaining housing inflation and consumption has turned unachievable.
I’m all for long-overdue legislative reform. Who isn’t? But I’ll say I heard nothing this week that came close to addressing the key issues. We have longstanding societal biases that place too much emphasis on housing and the stock market, while we operate with ingrained policymaking biases advocating unregulated finance underpinned by aggressive activist central banking and government market intervention. In a 20-year period of momentous financial innovation, our combination of “biases” proved an overly potent mix. And it is worth noting that Wall Street security/dealer balance sheets expanded three-fold in the eight years after the repeal of the (Depression-era) Glass-Steagall Act.
The focus at the Fed and in Washington is to sustain housing, the stock market, and inflated asset prices generally – to maintain the consumption and services-based Bubble Economy. Bernanke believes that if financial company failures can be averted - and with the recapitalization of the U.S. financial sector as necessary - sufficient “money” creation will preclude deflationary forces from gaining a foothold. He assures us the Fed will not allow double digit price declines, despite the reality that such price moves have engulfed real estate markets. And while the federal government “printing presses” will be working overtime going forward, it is also apparent that a key facet of Washington’s strategy is to “subcontract” the task of “printing” to Fannie, Freddie, the FHLB, the banking system, and “money funds” – sectors that can today issue “money”-like debt instruments with the explicit or implied stamp of federal government (taxpayer) backing.
Basically, the strategy is to substitute government-backed debt for the now discredited Wall Street-backed finance. I’m the first one to admit that this desperate undertaking stopped financial implosion in its tracks. However, the problem with this whole approach – because of our “societal,” financial, and policymaking biases – is that our Credit system will just be throwing greater amounts of (government-supported) debt on top of fragile Credit Structures underpinned largely by home mortgages. Wall Street-backed finance buckled specifically because this (“Ponzi Finance”) debt structure was untenable the day increasing amounts of speculative Credit were no longer forthcoming. The underlying inventory of houses doesn’t have the capacity to generate debt service – only the mortgagees taking on greater amounts of debt.
The underlying Economic Structure is now THE serious issue. The last thing our system needs right now is trillions more mortgage debt, although it would work somewhat to sustain consumption and our “services-based” Bubble Economy. The inherent problem with a finance, housing, consumption, and “services”-dictated Economic Structure is that it inherently generates excessive debt backed by little of real tangible value or economic wealth-creating capacity. It may appear an “economic miracle,” but for only as long as increasing amounts of Credit are forthcoming. At the end of the day, one is left with an extremely fragile Structure both financially and economically.
Yet as long as Wall Street “alchemy” was capable of creating sufficient “money” to fuel the boom - and the world was content in accumulating (increasingly suspect) dollar claims - our Bubble Economy Structure remained viable. It is, these days, increasingly not viable. The wholesale and open-ended government backing of U.S. mortgage debt - and financial sector liabilities more generally - will prove a decisive blow to already shaken dollar confidence. And it is today’s reality that the massive scope of Credit growth necessary to sustain the current Bubble Structure will correspond to Current Account Deficits and dollar outflows that will prove (as we’re already witnessing) only more destabilizing in markets and real economies around the world.
Government backing of our debt does not substitute for a sound Economic Structure. And it is the current Structure that is incapable of the economic output to satisfy domestic needs and generate sufficient exports to exchange for our huge appetite for imported goods and energy resources. Today’s “services”-based economy will no longer suffice. Examining today’s job data, one sees that 93,000 “goods producing” jobs declined in March after falling 92,000 in February and 69,000 in January. At the same time, Education, Health, Leisure and Hospitality jobs increased 178,000 during the first quarter. Yet it is more obvious today than ever that we need to consume less and produce much more.
Back to the “liquidationists.” It is my view that our economy will require a massive reallocation of resources. We will have to create much less non-productive (especially mortgage and asset-based) Credit and huge additional quantities of tradable goods. In the “services” sector, there will no choice but to “liquidate” labor and redirect its efforts. Throughout finance, there will be no alternative than to “liquidate” bad debt, labor and insolvent institutions – again in the name of a necessary redirecting of resources. After an unnecessarily protracted boom, there will be scores of enterprises that will prove uneconomic in the new financial and economic backdrop. “Liquidation” will be unavoidable.
Recent extraordinary government measures to “back” U.S. finance will likely delay the adjustment process – what I will be referring to as a “depression.” This reprieve, however, comes with a cost. It will ensure significantly greater damage to the core of our monetary system, as well as requiring a more onerous real economy “liquidation.”