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Lesson Unlearned
By
Henry C.K. Liu
This article appeared in AToL
on October 29, 2009.
An abrideged version appeared in NewDeal2.0 and the Huffington
Post.
October 29,
2009
is the 80th anniversary of the crash of 1929 that led to the
Great
Depression. Did the world learn the lesson of 1929?
Milton Friedman identified through exhaustive analysis of
historical data the potential role of monetary policy in shaping the
course of
inflation and business cycles, with the counterfactual conclusion that
the
Great Depression of the 1930s could have been avoided with appropriate
Fed
monetary easing to counteract destructive market forces. Friedman’s
counterfactual conjecture, though not provable, has been accepted by
central
bankers as monetary magic to rid capitalism of the curse of business
cycles. It
underpins the Greenspan-led Fed’s “when in doubt, ease” approach all
through
his 18-year-long tenure which led to serial debt bubbles, each one
biggest the
previous one. The final one burst in 2007.
Most macroeconomists, including current Fed Chairman Ben Bernanke,
subscribe to
the debt-deflation view of the Great Depression in which the collateral
used to
secure loans (or as in the current situation, the assets backing
derivative
instruments) will eventually decrease in value from excessive debt,
creating
losses to borrowers, lenders and investors, leading to the need to
restructure
the loan terms or even loan recalls. When that happens,
macroeconomists believe
that government intervention to supply liquidity is both necessary and
effective in keeping markets from failing.
The term debt-deflation was coined by Irving Fisher in 1933 to describe
the way
debt and deflation can destabilize each other. Destabilizing arises
because the
relation runs both ways: deflation causes financial distress for debt,
and
financially distressed debt in turn exacerbates deflation. This
debt-deflation
cycle is highly toxic in a debt-infested economy. The only way to
prevent it is
to not allow liquidity to flow into debt.
Friedman held out the false hope that central bankers could
negate debt-deflation instability with wholesale liquidity injections.
Hyman Minsky in The Financial-Instability
Hypothesis: Capitalist Processes and the Behavior of the Economy
(1982)
elaborated the debt-deflation concept to incorporate its effect on the
asset
market. He recognized that distress selling reduces asset prices,
causing
losses to agents with maturing debts. This reinforces more distress
selling and
reduces consumption and investment spending which deepen deflation.
This has
come to be known as the Minsky Moment.
Friedman’s counterfactual conclusions obscured the lesson
the world could have learned from the crash of 1929 and condemned the
world to
face another disaster again 80 years later.
In all, four false counterfactual conclusions on the 1929
crash accepted as economic truths have since given birth to an
economics of
instability:
False: Aggressive monetary easing measures can save the
economy from business cycle recessions. This conclusion led central
bank
monetarism to finance unsustainable debt bubbles. And only if the Fed
had
intervened earlier and firmly in 1929, it could have prevented the
depression
(Friedman). Bernanke is discovering in 2007 that this is not true.
False: World trade must be maintained to keep depression at
bay.
Fact: Under predatory terms of global trade based on currency
hegemony,
fueled by regulatory and wage arbitrage, world trade is the cause of
global
imbalance. Global free trade has been the prime cause for
domestic unemployment. As global free trade grew dramatically,
unemployment
and underemployment rose in both the US
and Chinese economies.
Solution: New terms of trade must be introduced to reverse
the adverse impact of international trade on employment, wages and
domestic
development. Restore international trade to augment rather than preempt
domestic development.
False: Only capital can create employment.
Fact: Under conditions of overcapacity, only full employment
with high wages can create savings/capital. Say’s law (supply creates
its one
demand) holds only with full employment. Without global full
employment,
comparative advantage in free trade is merely Say’s law
internationalized.
False: Comparative advantage in free trade is a win-win formula for
both
trading partners.
Fact: Comparative advantage has a fatal cost to the partner
who forgoes technological development in exchange for economic
efficiency in
trade. Ricardo, in analyzing trade between Britain
and Portugal,
failed to point out that by focusing on producing cloth, which required
mechanization, British gained a mechanized economy that gave it a
modern navy
to take over the Portuguese empire. Because Portugal
elected to produce wine in exchange for British cloth, it remained a
technologically underdeveloped agricultural economy and in time ceased
to be a
major power.
Solution: In a world order of sovereign states, weak national
economies must seek redress through economic nationalism.
October 29,
2009
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