By Mike Whitney
“We have involved ourselves in a colossal muddle, having blundered in the control of a delicate machine, the working of which we do not understand.”
— John Maynard Keynes
Black Tuesday. On October 29, 1929, the stock market crashed triggering the worst economic collapse in history, the Great Depression. Thousands of banks and businesses failed, shanty towns sprung up across the country, and 15 million Americans (25% of the workforce) lost their jobs. President Herbert Hoover, who believed the turmoil would be over in a matter of weeks, opposed providing aid to the needy and unemployed. He supported the same policies as his GOP heirs in Congress today who seek to deepen the present crisis by cutting unemployment benefits, slashing fiscal stimulus and balancing the budget on the backs of workers. The Hoover Doctrine was summed up by Treasury Secretary Andrew Mellon who famously said, “Liquidate labor, liquidate stocks, liquidate real estate…purge the rottenness out of the system.” Mellon’s views prevailed and by July 8, 1932, the Dow Jones Industrial Average had fallen to 41 points (an 89 percent drop from its peak in 1929) while the economy sunk into a decade-long slump.
Before the crash, stock prices had been propped up by massive amounts of margin debt that melted away in a deflationary inferno when the panic selloff began in late October. The calamity took down 4,000 banks and left the broader economy in ruins. John Kenneth Galbraith summed it up like this in his masterpiece “The Great Crash: 1929“:
“Had the economy been fundamentally sound in 1929 the effect of the great stock market crash might have been small. …. But business in 1929 was not sound; on the contrary it was exceedingly fragile. It was vunerable to the kind of blow it received from Wall Street. Those who have emphasized this vulnerability are obviously on strong ground. Yet when a greenhouse succumbs to a hailstorm something more than a purely passive role is normally attributed to the storm. One must accord similar significance to the typhoon which blew out of lower Manhattan in October 1929.” (Extracts from “The Great Crash: 1929”, John Kenneth Galbraith, First Published 1955, Page 204.)
The years leading up to the 2008 Financial Crisis saw similar trends as those before the Great Depression. It was also a period of extreme inequality and excessive risk taking. Credit-binging had inflated bubbles in housing and stocks clearing the way for a painful downturn and years of retrenching. The economy was also weak before the crisis, but the weakness was largely masked by the frenzy of credit spending that kept activity high. On August 9, 2007, the mask was stripped away when French-owned bank BNP Paribas suspended withdrawals at three of its funds because the value of the toxic mortgage-backed assets it held could not be determined. News of the incident spread quickly through the markets where trillions of dollars of mortgage-backed securities (MBS) were held by all the major banks and financial institutions. That set off a cascade of downgrades which ate away at bank capital and led to the collapse of Lehman Brothers.
When Lehman failed, all Hell broke lose; markets plunged, interbank lending slowed to a crawl, and forced liquidations wiped out trillions in capital. The unwinding continued for a full 6 months despite Congress’s $700 billion TARP bailout and the Fed’s blanket guarantees on all manner of dodgy financial assets. Finally, in mid-March 2009, the stock market hit rock-bottom and slowly began to recover. In contrast, the real economy remains stuck in a long-term Depression characterized by flagging output, falling housing prices, and high unemployment.
The basic problem facing the economy, is lack of demand. Stagnant wages, high unemployment and gross inequality have made a strong recovery impossible. Working people simply don’t have the purchasing power to generate positive growth. If it wasn’t for monetary and fiscal stimulus, the economy would be in recession right now. Even so, personal consumption has not slipped as much as one would expect. What has dropped off is investment, and, as author Robert Skidelsky notes, “In a growing economy, the gap between consumption and production must be filled by investment if full employment is to be maintained.”
So, why aren’t businesses investing?
Because working people are underwater on their mortgages, maxed out on their credit cards, and overdue on their bills. There’s no reason to build more capacity when consumers are struggling just to stay afloat. But that creates a big problem for the economy, because new investment is crucial to keeping things running smoothly. Here’s how John Bellamy Foster and Fred Magdoff explain it in their book “The Great Financial Crisis“:
“For a capitalist economy to work well the surplus (or savings) that it generates must be invested in new productive capacity. Yet, investment in modern capitalism…is at best a risky undertaking since investment decisions that determine the level of output in the present are based on expectations of profits on this investment…in the future…..Any lessening of investment tends to generate a vicious circle, pulling down employment, income, and spending generating growing financial problems, and negatively affecting the business climate generally—resulting in an economic slowdown.” (“The Great Financial Crisis”, John Bellamy Foster and Fred Magdoff, Monthly Review Press)
The recycling of surplus capital has hit a road-bump, so the economy has started to sputter. This situation should persist until household deleveraging ends and consumers regain their footing.
The Fed has tried to offset the lack of investment by inflating an equities bubble, but, so far, the results have been disappointing. The so called “wealth effect” has not boosted investment or trickled down to the broader economy. Demand remains weak and there are no signs of another credit expansion. Unless there’s a surge in borrowing, (which seems unlikely) the financialization process will slow and the economy will languish in a long-term slump. That appears to be what’s happening.
Last week, in his second press conference, Fed chairman Ben Bernanke claimed victory in his war against deflation. He said, “I think the point I would make about where we are today versus last August, is that then deflation was a non-trivial risk. I don’t think people necessarily appreciate deflation can be very pernicious.”
Is Bernanke right; is deflation no longer a threat?
Not likely. While the consumer price Index (CPI) has been on the rise, the fight against deflation is far from over. Consumers and households are still deleveraging, housing prices are falling and unemployment is stuck at 9 percent with 16.5 percent underemployed. Private sector debt is still at historic levels and will have to come down further. If that process is not eased by increasing the government’s budget deficits, then economy will shrink even more and lapse back into recession.
We’re at a point of extreme vulnerability. Bernanke’s bond purchasing program (QE2) may have temporarily lifted stocks and commodities out of the doldrums, but there are no guarantees that the trend will continue.
The question is whether consumers can maintain sufficient demand to power the economy by themselves or if deflationary pressures will reemerge as soon as the gigantic injections of monetary and fiscal stimulus run out?
Also, there are troubles are brewing around the world that could push the economy back into crisis. For example, many analysts now believe that China is headed for a hard landing. Here’s an excerpt from fund manager Gary Shilling’s 4-part series on China on Bloomberg News:
“China is much more vulnerable to an international slowdown than is generally understood…China’s reliance on exports and a controlled currency for growth, for instance, will no longer work if U.S. consumers are engaged in a chronic saving spree, as I believe they will be. Chinese export growth, which averaged 21 percent per year in the last decade, is bound to suffer….
Inflation Looming…China’s state-controlled economic boom may soon lead to crippling inflation. In February 2010, the director of the National Bureau of Statistics said that “asset-price increases pose a challenge for macroeconomic policy.”
The housing boom has pushed up prices to the point that apartments in Beijing are affordable to only the top 20 percent of earners — they’re selling at about 22 times average income (average U.S. house prices peaked at six times average income). A square meter of property in China costs an estimated 164 times per-capita income, compared with 33 times in high-priced Japan…
The government is fearful of rising prices, and has moved to prevent speculation. Buyers must now put down 60 percent of the purchase price on second homes, and 30 percent on first homes. The government is pressing banks to contain mortgages, and some have raisedinterest rates.” (“Shilling: China Heading for a Hard Landing”, Bloomberg)
So, why is China finding it so difficult to fight inflation?
Mainly, because a shadow banking system has sprouted up and is providing massive amounts of credit outside the traditional “regulated” banking system. That’s adding to the money supply and driving up prices. Here’s the story from guest author Waiching Li at Credit Writedowns:
“According to a study issued by the People’s Bank of China in 2010, non-banking sector lending has expanded to 63.3 trillion Yuan, ($10 trillion), 44.4% of total lending activities of China’s economy.
Shadow banking, a concept coined by the US Federal Reserve, refers to non-banking financial institutions with some banking functions, but they are not or less regulated like a bank. In the U.S., the lack of regulation for the securitization of traditional financial products, including home loans, was one of the major causes of the financial crisis.
Shadow banking in China mainly exists in the form of “Bank and Trust Cooperation”, the underground financing networks; but small loan companies and pawn shops also play a role in these shadow financing activities.
While mortgage securitization is not an issue in China, the “Bank and Trust Cooperation” is a vehicle to provide ‘hidden’ loans to enterprises outside the scope of the bank’s reserve limit. Similar to the credit securitization problems in the US, the banks play the role as an intermediary. ….
Data released on March 31th, by China Trustee Association, shows that the scale of Bank and Trust Cooperation as has already reached to 15.3 trillion yuan ($2.35 trillion). The risks of such financial arrangements are asymmetrically transferred to buyers. Since no credit ratings are available for these debts, the buyers have to blindly follow the bank’s referrals, hoping the banks, which make money from commissions and fees no matter what happens with the loan, have done due diligence and are honest.” (“The Shadow Banking Problem in China”, Credit Writedowns)
Unregulated “shadow” banking inevitably ends in disaster because loan-quality gradually deteriorates and that leads to panic selling. This is essentially what happened at BNP Paribas when they suspended withdrawals at their 3 funds; they became suspicious of the underlying collateral (subprime mortgages) and that sparked a bank run in the repo market. China will face the same problem if the government doesn’t reign in its shadow banks and control the flow of credit.
There are also troubles in the eurozone which could send the global economy sliding back into recession. George Soros warned last week, “We are on the verge of an economic collapse which starts, let’s say, in Greece, but it could easily spread…..The financial system remains extremely vulnerable.”
Greece will eventually have to restructure its debt as its debt-to-GDP ratio continues to widen each year it stays on its present payment schedule. Greek Prime Minister George Papandreou is willingly gutting public assets and laying off 20% of the public workforce to appease foreign bondholders who refuse to accept haircuts on their investments. Here’s economist Mark Weisbrot summing up the goings-on in Greece:
“Imagine that in the worst year of our recent recession, the United States government decided to reduce its federal budget deficit by more than $800 billion dollars – cutting spending and raising taxes to meet this goal. Imagine that, as a result of these measures, the economy worsened and unemployment soared to more than 16 percent, and then the president pledged another $400 billion in spending cuts and tax increases this year. What do you think would be the public reaction?
It would probably be similar to what we are seeing in Greece today, including mass demonstrations and riots, because that is what the Greek government has done…..Because of the massive opposition to further economic self-destruction – the latest polls show that 80 percent of Greeks are opposed to making any more concessions to the European authorities….
The IMF’s latest review of its agreement with Greece suggests that the Euro, for the Greek economy, is still 20-34 percent overvalued. This makes a recovery through “internal devaluation” – i.e., keeping unemployment so high and therefore lowering wages to make the economy more internationally competitive – an even more remote possibility than it would otherwise be. But the big problem is that the country’s fiscal policy is going in the wrong direction, and of course they cannot use monetary policy because that is controlled by the ECB.” (“Greek Protesters Are Better Economists Than the European Authorities”, CEPR)
While the Papandreou government has clinched enough votes in parliament to pass another phase of the EU’s austerity plan, this merely puts off the day of reckoning. Greece will not escape default. Eventually, the bondholders will be forced to take a hit on their investments and that will push the EU banking system (particularly English, French and German banks) into crisis. The meltdown may not be as big as Lehman, but it will certainly be enough to push the eurozone back into recession.
Lastly, GOP deficit hawks are threatening to trim government spending even though the economy is still too wobbly to stand on its own. If they succeed, the economy will contract and unemployment will rise. Here’s an excerpt from an article by economist Mark Thoma who explains the pitfalls of belt-tightening:
“…. widespread weakness in recent economic data makes a double dip much more likely. In May, just 54,000 jobs were added, auto sales declined significantly, retail sales were sluggish even excluding autos, and growth in manufacturing slowed sharply. Meanwhile, house prices continue to decline to new post-bubble lows, home sales have slowed, claims for unemployment insurance have risen, and consumer sentiment has weakened. Both stimulus spending and QE2 are coming to an end, state and local budgets are still a problem, and corporate bond issuance “fell to its slowest pace of the year.”…
…When the recession started, I was certain we wouldn’t repeat the mistakes of the past. One mistake in particular looms large right now, the deficit reduction and interest rate increases that sent the economy into a tailspin in 1937-38. Many people do not realize that there were two recessions within the Great Depression. The first, which came in 1929, is well known. This recession lasted until 1933, and then the economy began slowly recovering, much like today. As the recovery continued, people began to worry about the budget deficit and the possibility of inflation – again much like today. In response, fiscal authorities began reducing the deficit and monetary authorities raised interest rates, and the result was a second recession in 1937-38. This mistake prolonged the economy’s troubles considerably, and in part was why this became the “Great” Depression.” (“How the Fed Could Set Off a New Recession”, Mark Thoma, The Fiscal Times)
Regardless of the recent uptick in stock prices, the economy remains mired in a long-term slump. Demand is weak, because wages haven’t kept pace with productivity and because consumers no longer have easy access to credit. When consumers don’t spend, businesses don’t invest. It’s that simple. Big business is currently sitting on nearly $2 trillion for which there are no profitable outlets for investment. Unless investment picks up, the economy will continue to operate below capacity and unemployment will remain high.
Neither the Obama administration nor Congress believe that the government can play a constructive role in easing the business cycle or reducing unemployment. Policymakers still ascribe to a laissez faire orthodoxy which makes a protracted slowdown unavoidable. The only thing keeping the economy from a double dip recession is government spending. When austerity-minded congressmen slash the deficits, the last thread keeping the economy in positive territory will be cut and deflationary pressures will reemerge.