By Robert Romano — In 1991, before ascending to the Federal Reserve, then-Princeton University professor Ben Bernanke and Princeton colleague Harold James made the case that “nations’ adherence to the gold standard” caused the Great Depression, and those which quickly dropped the standard and engaged in monetary easing recovered quicker than those that waited.
Contrary to this conventional wisdom, in a recent piece, “Anstalt’s Shadow Looms Over Excessive Credit Today,” I took the view that, during the 1920s it was the credit bubble — and the feeble interwar gold standard that allowed it to come into being — that was the problem.
When the bubble was pushed to its outer limits, and bad loans had resulted in bank failures, the bust followed. Governments rushed in to guarantee the banks against losses, but the watered-down gold exchange standard could not sustain the boom. The world’s monetary system collapsed, and so did the economy.
Now, we will turn to the heart of Bernanke’s argument, which is that after the gold standard was dropped and monetary policy loosened in response to the crisis, supposedly recovery followed. This is important because even if the lax credit standards and easy money were the real culprits of the downturn, that in itself does not advise policymakers as to what the proper course of action afterward to clean up the mess might be.
It is particularly vital to examine this history because today we find ourselves in a similar situation, with high unemployment, collapsing asset prices, and no seeming end in sight.
So, did the suspension of the gold standard by 1936 worldwide, and for that matter Bernanke’s easy money response today to the financial crisis, restore full employment? Have no impact? Or did they only prolong the pain?
Hayek vs. Keynes (and Bernanke)
This is really not a new debate. In 1932, when Friedrich Hayek wrote his “Reflections on the Pure Theory of Money of Mr. J. M. Keynes,” he could have just as easily been responding to Bernanke when he warned that credit expansion would not get us out of the mess: “Any attempt to combat the crisis by credit expansion will… not only be merely the treatment of symptoms as causes, but may also prolong the depression by delaying the inevitable real adjustments. It is not difficult to understand, in light of these considerations, why the easy-money policy which was adopted immediately after the crash of 1929 was of no effect.”
Indeed, Hayek proved prophetic. Persistent, high unemployment in the U.S. endured throughout the 1930s — never dropping below 14 percent during the decade according to the U.S. Census Bureau — even after the elimination of the gold standard in March 1933. This sorry state of affairs prevailed until the onset of World War II.
Only then did unemployment drop back to desirable levels.
But even then, the Keynesians (and monetarists) have argued that because authorities waited too long to loosen monetary policy, everything that followed stemmed from that failure.
Now, Bernanke has had his opportunity to prove Hayek wrong once and for all. But after more than tripling the Federal Reserve’s balance sheet from $869 billion in 2007 to $2.8 trillion today — its greatest expansion in its century-long history — unemployment is still unacceptably high at 8.2 percent, with some 28 million people who cannot find full-time work or have simply given up.
Is Bernanke prolonging the depression with easy money by preventing the real adjustments from occurring, as Hayek warned against? In short, are we fighting the future? Something to consider as the Federal Reserve contemplates another round of quantitative easing.
Certainly the monetary expansion hasn’t visibly helped. As recently noted by frequent RealClearMarkets.com contributor, Chief Investment Strategist of Alhambra Investment Partners Jeffrey Snider, in a criticism of Bernanke’s policies, “central banks have gone to extra-ordinary lengths (even quasi-laundering) to ensure monetary flexibility, or at least the opposite of whatever the gold standard imposed on the real economy, and we end up largely in the same state anyway”.
So, gold standard or no, we have wound up in precisely the same predicament. So, tell us another one. It seems more likely that it is the deleveraging off of bad debts — i.e. the credit bubble letting its air out — that is propelling these events, not the chosen monetary unit of exchange.
Monetary debasement the common thread, but where will it lead?
If so, then currency debasement and excessive credit are the common threads that tie these two crises together. It first leads to credit bubbles, erodes the concept of value, and causes irrational investments. But eventually the bubble pops, and brings with it depression, political instability, tremendous expansions of the state, and eventually, if allowed to persist, war.
Today, we are running the same risks.
But there are other possible outcomes which seemingly may be even worse. One need not focus entirely on modern history, such as the 1920s and 2000s credit bubbles, Japan’s 1980s bubble followed by its lost decade, or even more localized incidences as the Weimar Republic and Zimbabwe to find examples that the destruction of the monetary unit has raised on the world economy.
In 1949, Ludwig von Mises in Human Action observed similarly bad outcomes in the fall of the Roman Empire, writing how price controls and currency debasement in the third and fourth centuries upset the economic interconnectedness of the Roman Empire and “completely paralyzed both the production and the marketing of vital foodstuffs and disintegrated society’s economic organization.” The policies eventually led to shortages, causing people to flee the cities, who returned to subsistence farming.
Subsequently, large agricultural estates lost their customer base, curtailed production, and then the owners could no longer afford to spend in the cities. Estates were converted into rental lands for sharecroppers, became self-sufficient, and feudalism was adopted — long before the Empire had even fallen.
The Empire per Mises had “returned to a less advanced state of the social division of labor. The highly developed economic structure of ancient civilization retrograded to what is now known as the manorial organization of the Middle Ages.” By the time the barbarians arrived, the Empire had already defeated itself.
The end of globalization?
While it is highly unlikely that the end Mises observed for Rome would happen today, could globalization collapse under the weight of the credit contraction? And would that be such a bad thing?
If the global economy relies on excessive credit to move goods and services about, how will local economies respond to the credit bubble popping over the next decade? Will we return to more localism and self-sufficiency ten years from now, or will we be able continue to import cheap goods from the Far East and elsewhere?
The trend away from globalization may already be taking root, with Chinese manufacturing continuing to contract — their manufacturing Purchasing Managers Index for August at 47.8 was down from 49.3 in July, reflecting falling orders. If exporting, emerging economies cannot find customers in the West, they may need to transition production for their own domestic sectors. This in turn may incentivize more domestic production of goods in the U.S. and elsewhere.
Eerily, the BBC reports that in Greece, where a government credit bubble proved unsustainable and now unemployment tops 23 percent, including youth unemployment at 55 percent, there is a increasing trend for citizens to live in self-sustaining eco-communities, growing their own food, engaging in barter, and trading surpluses with other villages. Sound familiar? Is Greece a window into the world’s feudal future?
That might be the more favorable outcome when the alternative is considered.
We know how this movie ends. The last time in modern history when such expansive monetary policies were attempted on a global scale to overcome depression, full employment was not restored.
Instead, it led to highly volatile political environments in democracies and dictatorships alike, and eventually, war, as states took the allocation of resources into their own hands as a matter of policy — and governments attempted to find something to do with their surplus unemployed populations.
Many economists agree that the Great Depression was ended only by a cataclysmic world war. Milton Friedman along with Anna Schwartz in their “Monetary History of the United States” attributed increases in the money stock due to the outbreak of WWII in Europe with facilitating recovery starting as early as 1938 and continuing through the war.
In a 2002 interview with Randall Parker in “Reflections on the Great Depression,” Friedman took on that view even more directly, saying, “The standard answer to the question ‘What ended the Great Depression?’ is World War II and government spending for armament. There is a sense in which that’s right because that government spending for armament was financed by printing money.”
As Friedman and Schwartz observed in their book, prices did in fact rise after the war. Deflation — one of the primary symptoms in the Depression — had been defeated. Unemployment too ticked up a bit after the war, but not back to the levels seen during the depression. Ergo, the war stopped the depression.
In other words, it took credit expansion on a massive scale that only a war can produce to get us out of the slump that the credit bubble had created and to restore full employment. But at what cost?
Let us all hope that another 50 million people don’t have to perish on the altar of this same failed monetary policy. As governments grow desperate to “do something” about today’s depression, that will increasingly become a real risk.
Credit card already maxed
But there are limits to how much credit can really expand. As private sector deleveraging continues, the only other area where debt can expand right now is via the government. In World War II, that meant increasing the national debt from $48.9 billion to $258.2 billion — a quintupling — as it grew from 38.5 percent to 115 percent of GDP by 1945.
But with a national debt-to-GDP ratio already over 100 percent, its highest level since the end of World War II, and interest payments on the $16 trillion debt over $454 billion and rising to $1 trillion by 2022, is a repeat of 1941-45 even possible? How much more can government debt grow before we face a funding crisis similar to Europe’s?
It is clear the debasement cycle has produced much ruin throughout economic history, and today it is no different. Still, we are consistently told more devaluation is the answer to all of our woes.
It isn’t. Overall, as I wrote in “The Great U.S. Credit Conundrum,” it might take an additional $50 trillion or so of credit expansion, both public and private, this decade alone to restart the dynamics seen during the debt supercycle of 1945-2008 when credit outstanding roughly doubled every single decade. That is simply not sustainable. We have already maxed out the credit card, and thus need another way.
We need sound money. The risks posed by debasement policies should be sobering for anyone who seeks a better future for their children and grandchildren. This is no longer simply an academic debate. The global consequences of these policies may very well now be at our doorsteps.
Robert Romano is the Senior Editor of Americans for Limited Government.