Great Crises of Capitalism (1)

P. D. Jonson (aka Henry Thornton) has written Great Crises of Capitalism, a history of economic crises in capitalism since the C17th and a jeremiad against inflation. It is clearly provoked by the Global Financial Crisis (GFC) of 2007-08, which the book begins with a survey of, and the subsequent Great Recession whose consequences Australia largely avoided but the US and other major Western economies are still suffering the effects of.

Jonson notes that financial booms and busts have recently been getting generally greater in amplitude (as measured by change in asset prices from height of boom to depth of bust). He also argues that, with the rising economic significance of China and India, goods and services inflation has been restrained, so easy money has spilled over into asset booms. (That is, global supply has continually responded to increases in money offers so as to keep inflation low: the weakness in this argument is many goods and services are not globally traded, though the range of these is diminishing – and non-traded goods and services are considered later [Pp235ff].) Jonson faults Alan Greenspan in particular for encouraging the notion that Central Banks should ignore asset price booms (p.18).

Follow the money
Another way of looking at this is that Jonson is, in effect, taking the classic Fisher equation of MV = PT (money x velocity [average number of transactions money goes through in a given time period] = price x transactions [in that time period]) and saying the restriction of T to current transactions (thereby leaving out asset transactions), so using CPI or some derivative thereof as the measure of P, and thereby ignoring asset prices, is a fundamental error. (Jonson points out that Milton Friedman’s model implicitly assumed a single good and a single asset, money, leading to inflation being defined in terms of goods and services [Pp17-8].)

A recent review of Earl J. Hamilton’s classic American Treasure and the Price Revolution in Spain, 1501-1650 nicely sets out the basic economics of the Fisher equation:

Most economics students are familiar with Fisher's Equation of Exchange, to explain the Quantity Theory of Money in a much better fashion than nineteenth-century Classical Economists had done: namely, MV = PT. If many continue to debate the definition of M, as high-powered money, and of P — i.e., on how to construct a valid weighted CPI — the most troublesome aspect is the completely amorphous and unmeasurable "T" — as the aggregate volume of total transactions in the economy in a given year. Many have replaced T with Q: the total volume of goods and services produced each year. But the best substitute for T is "y" (lower case Y: a version attributed to Milton Friedman) — i.e., a deflated measure of Keynesian Y, as the Net National Product = Net National Income (by definition).[note 55: For various reasons, too complex to discuss here, I prefer to use the Gross National Product - as many economic historians, in fact do, in the absence of reliable figures for Net National Product.]

The variable "V" thus becomes the income velocity of money (rather than Fisher's Transactions Velocity) — of the unit of money in the creation of the net national income in the course of a year. It is obviously derived mathematically by this equation: V = Py/M (and Py of course equals the current nominal value of NNI). Almost entirely eschewed by students (my students, at least), but much preferred by most economists, is the Cambridge Cash Balances equation: whose modernized form would similarly be M = kPy, in which Cambridge "k" represents that share of the value of Net National Income that the public chooses to hold in real cash balances, i.e., in high-powered money (a straight tautology, as is the Fisher Equation). We should be reminded that both V and k are mathematically linked reciprocals in that: V = 1/k and thus k = 1/V

Thus kPy equals the demand for money and changes in k for a given level of M will lead to changes in Py. So, for example, if people expect deflation (and so wish to delay purchases and increase their k since they expect money to increase in value) then the withdrawal of money means either prices must fall or national product must fall, or both (with the balance depending on how downwardly responsive prices are). Conversely, if people expect inflation (and so wish to bring forward their purchases, and decrease their k, since they expect money to decrease in value) then either prices must rise or national product must rise, or both (with the balance depending on how upwardly responsive supply is – hence Jonson’s point about rising Indian and Chinese production reducing global inflationary pressures).

Clearly, expectations matter: for example, the belief that one has to get into the housing market as soon as you can because prices will keep rising faster than income is classic inflation-expectations behaviour.

As an historical aside, one can see how the flow of silver from the Americas in the C16th and C17th would have had price effects on its own, since the silver did not appear everywhere instantaneously, but passed through a series of hands; so there would be a lag in k responses, leading to an increase in P given that the silver kept flowing in and did so in patent excess of the ability of supply (y) to respond to the increased money offers (M/k=Py) within the European economy. Conversely, since only about a third of the silver went to purchase goods and services from the (much larger) Asian economy, and transport costs and official monopolies blocked convergence in prices (pdf), any price effect in Asia would have been much smaller, leading to European goods being priced out of Asian markets (except where they had no competitors) and Asian goods being priced into European markets.

About assets
Even in the explanation quoted above, we can see that there has been a move from considering all transactions and all prices to considering consumer prices only (and thus ignoring asset prices: even that part of National Product spent as investment). But money can be used to purchase consumer goods or assets. So our author has a plausible point.

Not that these macro considerations means that the characteristics of different specific markets do not matter. On the contrary, they matter a great deal. For example, money will clearly be attracted to assets where people have high expectation of income or capital gains (that is, downside risks are discounted). Such as housing markets with constricted supply; financial instruments where there has not (yet) been experience of problems or weaknesses or financial markets where explicit or implicit government guarantees have undermined prudence. The US brought all these things together in a “perfect storm” of (land) supply-restricted housing bubbles, sub-prime mortgages and Fannie Mae and Freddie Mac (as usefully discussed in this review of and also this review of a recent book on the matter).

Jonson notes that, in Australia:

By March 2007, compared to June 1986, consumer prices had slightly more than doubled, implying annual goods and services inflation of 3.8%. Over the same 21 years, average house prices had risen by 450%, the share price index had risen by a similar 480% while shares in BHP Billiton haqd soared by a massive 1150%. While the out-performance of BHP Billiton shares were in part, perhaps in large part, due to the ‘China boom’, other asset prices had risen by an order of magnitude faster than prices of goods and services (p.17).

Jonson’s argument about asset prices does point to a lacunae in mainstream economic thinking. But I disagree with some of his economic history, particularly his dismissal of the medieval economy. Jonson writes:

The strong inflows of Spanish gold and silver gave a pronounced stimulus to economies that had stagnated for centuries (p.40).

First, the dramatic increase in silver production from central Europe (based on technological advances) began well before the arrival of Spanish and Portugese gold and silver. Second, the medieval economy was far from stagnant: on the contrary, it was a highly adaptive economic system which created the first mass machine economy. The cathedrals were not signs of a stagnant economy. The Serene Republic of Venice in 1330 had more sophisticated capital markets than Qing China in 1830 (bonds were invented by the Serene Republic in 1171): indeed, financial innovation was likely at least as important in explaining the Great Inflation of the C16th and C17th as Central European and American silver.

Historical infelicities
There are also some simple historical errors in the book, such as that East Germany was not the People’s Republic of Germany (p.47), it was the German Democratic Republic. The Spanish influenza killed about the same number as killed in the fighting in the First World War, not half (p.48). I think one can reasonably claim that Japan joined the modern world before the A-bombing of Nagasaki and Hiroshima (p.209). There is also the odd failure of editing, such as:

When President Nixon devalued the US dollar against gold in 1971, the Japanese yen was set at ¥308 per $1, which compares to around 50 cents per US dollar at the start of the twentieth century (p.211).

This makes no sense, presumably ‘cents’ should have been ‘yen’. While in a sense the US won the Cold War due to much greater wealth than its Soviet rival (p.61), that was a result of a superior economic system, not some freestanding fact.

Jonson’s story about Sir Francis Drake’s looted Spanish treasure setting off a series of investments culminating in the East India Company being the source of England’s foreign investment (p.58) is a “lucky happenstance” analysis that is a completely inadequate explanation of why England (and the Dutch Republic) proved so much more successful than Spain and Portugal at taking long term advantage of the commercial opportunities of the European global commercial expansion. Massive flows of silver were not an asset, they were a long-term disaster. But if you have a dismissive attitude to medieval Europe, such a “they were lucky” analysis gains spurious plausibility. Jonson also keeps referring to Spanish gold (e.g. ‘vast gold fleets’, p.62) when silver was much more important.

Jonson is not adverse to some rather un-pc observations – such as ethnic Chinese integrate into democratic capitalist countries rather better than Muslims typically do (p.61): one of those embarrassing truths folk are not supposed to mention.

Jonson provides a brief potted history of great power struggles from the C16th to C20th, relying on Kennedy’s Rise and Decline of Great Powers (a study which sadly concluded by claiming that late 1980s America was suffering worse “imperial overstretch” than the Soviet Union) and Blainey’s The Causes of War (a much better book which Jonson relies rather more on) (Pp60ff).

Sometimes, one could wish for more economic history. Jonson’s:

There is clearly something deep in human character that is driven towards expansionism (p.68)

is not a helpful analysis. That people like wealth and rulers-cum-states like revenues are pretty straightforward reasons for both the expansion of farming (which has been going on for 10,000 years, since farming first began) and for imperialism (which has been going on since rulership first established itself, so at least 5,500 years).

Jonson raises the hardy perennial of how much ideological conflicts reflect underlying economic interests or tensions (Pp71ff). His suggestion that the American South could have won independence in the American Civil War by using insurgency tactics (p.74) seems to be based on the common Vietnam War-era misconception that insurgencies are naturally successful (most insurgencies fail) and is deeply implausible given an occupying North would have had the black population in support. But Jonson’s wider discussion of the connection between war and economies is nicely nuanced and thought-provoking (Pp74ff).

[This review continues in my next post.]