Monday, May 23, 2011

Great Crises of Capitalism (2)

This continues my review of P. D. Jonson (aka Henry Thornton) has written Great Crises of Capitalism. The first part is in my previous post.


History matters
After the first three chapters (on the GFC, role of crises in capitalism, plus war, peace and capitalism) set the stage, the fourth chapter is engagingly, and provocatively, titled The Dutch Tulip Boom of 1636; with Brief Comments on the Modern Market for Art. Taking us through the Dutch Republic’s success, particularly its role in financial innovation, Jonson summarises the Tulipmania as described in Charles McKay’s cultural classic Memoirs of Extraordinary Popular Delusions and the Madness of Crowds and then a more recent examination of the episode by Peter Garber, examining the difficulty of defining a ‘bubble’ in a way that is genuinely informative at the time, rather than only in retrospect (Pp79ff).

This is a genuine difficulty, since the point of asset price bubbles is that their turning points are not systematically predictable: if they were no one would get caught in them. It is the lack of predictability which makes bubbles possible in the first place.

Jonson makes the point that the prices of assets of different classes tend to rise and fall together, particularly in general crashes (p.94). The more fundamental lesson this suggests is to limit one’s debt exposure. Jonson’s point that likely the worst effect of Tulipmania was its undermining of ‘trust and honour’ is surely a powerful one.

His discussion of the booms in art prices associated with wider booms is rather whimsical in tone. As an activity of the extraordinarily rich, he does not think it a public policy problem – particularly as the pieces often end up on public display in museums (Pp91ff).

Then it is on to the South Sea and Mississippi bubbles of the early C18th. This is an amazing pair of stories. In both England and France the state was burdened with massive public debts it could barely manage to service. An able economist, gambler and scallywag, John Law, proposed to the French Regent a system of note issue to improve liquidity and thus economic activity: in effect, creating a central bank. This worked so well that the Regent decided more was clearly better. One thing led to another, and there was an enormous bubble followed by a dramatic crash.

England already had a central bank, the Bank of England: indeed, the original central bank. That the English central bank, far from being a participant in the English bubble, was engaged in a struggle against those at the centre of the South Sea bubble, limited the damage; though there was great rage against those felt to be culpable when the bubble burst.

In England, there was to be improved management of a consolidated national debt that was to permit the United Kingdom to fight major wars, successful (War of the Austrian Succession, Seven Years War), unsuccessful (War of American Independence) and long and eventually successful (French Revolutionary and Napoleonic Wars) while maintaining sound finances. Improvement in public finances in France from John Law’s innovations was temporary, and accompanied by much economic and social damage. As Jonson observes:
a leading edge in innovation can so easily become a bleeding edge (p.81).
The failure to deal with the underlying fiscal problems was to result in the Bourbon monarchy eventually being effectively bankrupted by a successful war (War of American Independence) and collapsing in revolution (Pp97ff).

A pop culture aside: Terry Pratchett’s Making Money is a splendid fictional take on some of these issues, with protagonist Moist von Lipwig likely being partly based on John Law, but one working for a competent autocrat, not a silly and greedy one.

The grand century
We then move onto the nineteenth century, concentrating on the UK and the US and a potted history of economic cycles in the US and UK, with supporting graphs and table focusing on the interaction between the gold standard, credit and railway speculation in particular. There seems to be a quasi-Austrian malinvestment theory behind Jonson’s analysis, except he points out that the railway investments turned out to be economic boons. I find the Austrian concept of malinvestment unpersuasive. There does not seem to be any useful general concept of ‘malinvestment’ that is independent of the level of economic activity. Sure, businesses fail but they do so all the time, even in the height of booms, and this discovery process is surely much more about exploring boundaries of what is or is not profitable (boundaries which shift as the level of economic activity shifts) than displaying some inherent characteristic. Yes, one can get inappropriate construction (e.g. empty housing estates in post-bust Ireland or various US cities) but they were the result of very specific forms of perverse incentives, not indicative of some general phenomenon, even in housing construction (even if you add in various complications).

Our author does fall into a common flaw of works of economic history, in failing to explain important features to readers. Specifically, a paragraph, or even a sentence or two, explaining why the Bank of England raised the Bank Rate (merely defined in the text as ‘a key contributor to economic stability under the gold standard’ [p.123]) in crises would have been very useful. There is a useful glossary of terms, which tells us what the bank rate is, but does not explain this crucial dynamic (Pp121ff).

Jonson has a nice eye for a good quote:
’A currency system which in difficult times,’ says Clapham, ‘depends on the chance occurrence of nuggets in gulches and gold dust in river sands lack stability (p.134)’.
Gold standard enthusiasts point to the stability of (goods and services) prices under the gold standard, but it is a stability which can lead to considerable instability in employment and economic activity, a factor that gains increased force given there is reason to believe that the degree of “stickiness” in prices and (particularly) wages has increased over time. The gold standard has also been compatible with wild swings in asset prices.

Leaving the nineteenth century in US and UK with praise of innovation and the warning that:
Prosperity often leads to over-exuberance and is often accompanied by fraud and incompetence, which helps to explain why prosperity often turns out to recession or depression (p.142).
Jonson moves on the “Marvellous Melbourne” and the extraordinary story of the Victorian land boom.

Antipodean occurrences
We start with a refreshingly (generally) positive portrayal of the energy, innovation and progress of the period, including Australia’s role as a pioneer of representative democracy, interspersed with references to Jonson family history (Pp143ff). In the midst of this (mostly) positive economic history, there was a land boom-and-bust in the late 1830s and early 1840s as wool prices surged then collapsed.

What Jonson labels – with an explicit invocation of recent American experience – as the ‘sub-prime land boom of the 1880s’ was built on two pillars: a plethora of building societies and a belief that it was impossible to lose money by investing in land. (This should sound very familiar.) What made things worse was that Victorian building societies were permitted to invest in real estate themselves. Prices surged: land prices in the CBD could double in price in a matter of months. When the boom busted, the crash was spectacular. Suburbs were built that remained untenanted for years; 20 major financial institutions closed, 120 public companies failed, high levels of fraudulent behaviour were revealed, there was massive unemployment accompanied by deprivation, misery and death (Pp151ff). It is hardly surprising that Melbourne became a bastion of labour and protectionist politics.

This is followed by a short economic history of Australia, where the period from 1900 to 1972 is covered rather more briefly than the period from the Whitlam Government on, interspersed with references to the author’s family and personal history. But the public policy history from 1972 onwards is very usefully covered, by someone who was a senior ‘econocrat’ for much of that time, concluding with a survey of current issues. That housing seems both clearly overvalued but has potential for future housing shortages just reminds us of the unknowability of the future (Pp161ff).

Income and expectation
My take on that is that rental prices tell the supply-and-demand story and value above a reasonable capitalisation of current rental (i.e. income) value tells the “bubble” story. (If a good return on an asset is 6%, take the annual rental value, divided by 6, multiply by a 100: that is the reasonable capitalisation of current rental value.) Except, of course, some of the excess price over said capitalisation may be (reasonable) expectation of future rental rises: that little difficulty of the unknowability of the future again. Still, one can do the check in reverse: take the current price, divide by 100, multiply by 6 – is that a reasonable expectation of future rents? If not, then there is in the price of the asset an expectation of capital gain beyond reasonable expectations of its future income value and we are in bubble territory.

That part of the price which is based on expectations of pure capital gain beyond income value can vanish astonishingly quickly if those expectations go away: which they do as soon as prices start falling sufficiently. Hence the sudden asset price “busts”. Which is unfortunate: it only becomes a disaster if it was the basis for debts, for one is then left with the debt without the asset value that was backing it. It becomes a catastrophe if lots of folk are in that position and suddenly financial institutions have a massive surge in “bad debts” – loans people cannot pay back and which are not covered by realisable assets. The loss of income and assets can destroy financial institutions and devastate capital markets leading to a dramatic drop in economic activity as people lack the funds to engage in transactions, or take their money out of the financial system, or simply stop transacting for prudential or anticipated rising-value-of-money reasons (since money in circulation is becoming more scarce).

A proposal
So, the truly risky form of debt is debt beyond the income value of an asset. Hence my suggestion that people simply be banned from borrowing against an asset beyond its capitalised income value. If people want to bet on capital gains beyond that, fine: but they can do it (only) with their own money, not on credit.

This is not some puritanical dislike of “speculation”, just a prudential concern to minimise systemic risk in the financial system. It would also take a lot of the “heat” out of asset price booms, as it would effectively eliminate the use of credit to generate expectations of capital gain beyond income value. It is not a proposal for perfection, merely of prudence. There would be some cost at the margin (that problem of reasonable expectations of future income gain) but the benefits would surely greatly outweigh that: the most one can hope for in any regulation. Moreover, it would actually increase information in the market, by forcing attention to how much of a price is current income value and how much expectations of capital gain (the problem with much regulation is that it either destroys or distorts information).

Roaring boom, savage bust
Jonson then moves back to wider economic history with his next chapter The Roaring Twenties and the Great Depression. The chapter has many quotes from Galbraith’s (highly quotable) The Great Crash, an account Jonson labels “sardonic and authoritative”, while Milton Friedman and Anna Schwartz’s magisterial A Monetary History of the United States only gets a role in the commentary towards the end.

The public policy question Jonson concentrates on is the proper role of a central bank in the face of a boom in asset prices. One of the major speculators, Charles E. Mitchell, became a director of the New York Reserve of New York, a blatant conflict of interest (p.172). Raising the rediscount rate was proposed to cool speculation (since it would have reduced the profit on broker’s loans) while controlling margins (what proportion of cash had to be put up to buy stocks) could also be used to discourage speculative borrowing. The Reserve merely issuing a statement in February 1929 caused the share market to drop and then stall, particularly as the attitude of the new President (Hoover) was unclear.

Then Mitchell stepped in and made it clear his bank would support what the Reserve had warned against. The market rallied, the Reserve was silent: as Galbraith wrote, it had decided not to be responsible for a market crash and the share price boom restarted (Pp173-5). This is a basic problem: what central bankers wish to be responsible for a crash? The post-Depression joke – the role of a central banker is to take the punch away just as the party is getting started – is not a counsel of popularity. And the further away the memory of the last big boom-and-bust is, the less credence there is likely to be that the alternative is worse. Particularly as technological and financial innovation can so easily feed the delusion that “this time is different”.

The market surged on the belief that there was a “shortage of securities”, which much human ingenuity went into addressing, the use of credit to buy stocks surged (such loans being safe – as long as the market continued to rise) and various commentators supported the siren song “this time is different”. Prof. Irving Fisher, who Milton Friedman regarded as the US’s greatest economist, made his infamous statement that ‘stock prices have reached what seems like a permanently high plateau’, while doomsayers were sharply criticised (Pp176ff). The discrediting of free commerce advocates by their spruiking of the boom and the severity of the subsequent bust was to have major political, public policy and intellectual consequences.

Fisher himself was to develop his debt-deflation analysis (pdf) of the subsequent Depression, which was largely ignored at the time but, decades later, was to become more influential.

Then the stock market crashed, with expectations of gain being replaced by fears of loss and lack of information (such as the ticker falling behind, or Sunday market closure) becoming an increaser of fear:
After the Great Crash came the Great Depression which lasted, with varying severity, for ten years. In 1933, America’s Gross National Product was nearly a third less than in 1929. Not until 1937 did the physical volume of production recover to the levels of 1929, and then promptly slipped back again. In 1933, nearly thirteen millions were out of work, or about one in four of the labour force. In 1938 one person in five was still out of work (Pp180-1).
In Australia, whose governments had run up massive public debts, the surge in unemployment was likely even worse than in the US and the struggle to service the debt as incomes crashed dominated politics (Pp178ff).

Jonson wrestles with the question of what caused the Great Depression without coming up with a clear answer: as there is no scholarly consensus on this subject, this hardly surprising. He notes that Friedman and Schwartz’s analysis of severe contraction in money supply is the generally accepted explanation for the severity of the Depression. Ben Bernanke, the current Chair of the Fed, provided evidence for a severe contraction in credit whose effect was even greater than the money supply contraction. The Smoot-Hawley tariff increases and increases in taxes did not help (Pp182ff). As well:
There was an irrational fear of inflation while the country was experiencing the most violent deflation in the nation’s history (p.186).
A pattern we have seen replicated in recent times.

Meanwhile, in Australia, tariffs were raised, quotas and foreign exchange restrictions were imposed, limiting trade. But there was also a massive currency depreciation and a 10% nominal wage cut while the options of default, deficit spending or balancing the budget dominated politics. Jonson feels it is likely that the currency depreciation and wage cut, plus business unhappiness with FDR’s Administration, were the prime reasons why Australia recovered from the Depression quicker than the US (Pp186ff). As for lessons learnt since, the Greenspan view that it is not the job of central bankers to act against asset bubbles (as distinct from cleaning up afterwards) became widely accepted. When the GFC and Great Recession crisis hit, the response – cutting interest rates, swapping private assets for cash (‘quantitative easing’), bailouts and fiscal stimulus – were all adopted “with almost religious fervour”, a dramatic contrast to the policies of the early 1930s (Pp188-9).

Stagflation
Then we are on to “the Age of Aquarius” and the rise of stagflation – inflation with unemployment – and a period where the author can rely more on personal experience. Inflation is denounced:
Misery is inevitable in any economy as inflation erodes the value of people’s investments, raises their cost of living and makes contracts difficult to adjust and in some cases impossible to enforce (p.191).
Made worse if people also lose their jobs and others fear doing so. Since this was the time when the Phillips Curve had appeared to provide a clear trade-off between (goods and services) inflation and unemployment, the conjunction of inflation with unemployment – which reigning theory said was impossible – caused confusion and conflict in policy circles (Pp191-3).

The analytical breakthrough was to add expectations about inflation into the analysis. As inflation rose without effective counter action, so did inflationary expectations:
both rose largely independent of the state of the economy as measured by unemployment (p.194).
The link between unemployment and inflation was broken, with rising costs of inflation driving up unemployment. (More precisely, the ‘equilibrium point’ of unemployment.) There was an extra complication:
It is a basic theorem of economics that small open economies with a fixed exchange rate will import the global rate of inflation (Pp195-5).
The last effectively meant the US rate of inflation. On August 15, 1971 President Nixon broke the last link between gold and the US dollar, so there was no ‘anchor’ for inflationary expectations beyond people’s expectations about the actions of the US Federal Reserve (and their effects).

This point was not as widely understood at the time as it might have been. The battle between “cost push” and monetary explanations was fought out, being (mostly) won by the monetarists. The new Chair of the Fed, Paul Volcker, changed the Fed’s operating procedures. This led to the Federal Funds rate rising to 20% in June 1981: unemployment surged, but the recession was short and (goods and services) inflation collapsed to 3% p.a. Appointed by President Carter, re-appointed by Reagan, Jonson labels Volcker:
history’s greatest central banker, its most effective inflation fighter (p.197).
It took other countries rather longer to catch up, requiring as it did flexible exchange rates and abandonment of the hope of painless solutions. Jonson covers the arguments over floating the Australian dollar, which the author supported against the objections of then Treasury Secretary John Stone, who was opposed on the grounds that loss of financial reserves was a stronger constraint on fleckless government (Pp197-8).

The rest of the chapter is devoted to a lengthy discussion of the costs of inflation, the costs of stopping inflation and judging the balance thereof. Jonson is firmly of the inflation-as-scourge view, which policy needs to be constantly alert against: one of the costs of persistent inflation being the drop in household saving (Pp198ff). Expectations of capital gain in house prices become an alternative “saving” strategy: one using credit and dependant on what goes up not coming down.

[This review will be concluded in my next post.]

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