Not Your Garden-Variety Economy

The Daily Reckoning PRESENTS:Why does America have the weakest recovery despite the most prodigious policy stimulus in history? If the economy’s downturn was unique in its pattern, so also was the pattern of its upturn. The Good Doctor explores…


In short, the 1920s were an era of worldwide credit expansion. Its most spectacular phase was the large-scale financing of inflated security and real estate values, especially in the United States. Such over-capitalized values were not reflected in the price level indices, which have generated confusion. Both Lauchlin Currie and Friedman and Schwartz have insisted, as have many others, that there was no inflation in the 1920s, since “prices” did not rise.

– Melchior Palyi, The Twilight of Gold, 1914-1936, 1972

Since Benjamin Bernanke’s nomination by President Bush to succeed Alan Greenspan at the helm of the Federal Reserve, it has been widely reported that Bernanke had fixed his earlier professional career as a professor of economics upon the study of the cause or causes of the 1930s Great Depression, with the intent to make sure that this will never happen again.

At a conference in 2002 honoring Milton Friedman’s 90th birthday, he expressed contrition on behalf of the Federal Reserve: “Regarding the Great Depression, you are right, we [The Fed] did it. We are very sorry. But thanks to you, we won’t do it again.”

Wondering about Mr. Bernanke’s academic research, we took a closer look at his earlier writings and contemporary speeches. We learned that he did “groundbreaking research on how declining asset prices and weakened banks can choke off new lending and economic growth, and how the mistakes of the Federal Reserve compounded the catastrophe.”

America’s Great Depression was by far the greatest economic and financial disaster in history. Yet it strikes us that the discussion in the United States has been stuck in the assertion that the Fed’s failure to ease its reins fast enough was key to the savage asset and price deflation that followed during the 1930s.

The question of what may have gone wrong during the prior boom to cause the Depression has always been discarded as beside the point, with the argument that the extraordinary price stability prevailing in the 1920s represented conclusive evidence of the absence of any inflationary influences.

For most American economists, the verdict of Milton Friedman and A.J. Schwartz at the end of their Monetary History of the United States, 1867-1960, published in 1963, about the causes of the Great Depression, is virtual dogma. And so it is for Mr. Bernanke. To quote Friedman:

“The stock market boom and the afterglow of concern with World War I inflation have led to a widespread belief that the 1920s were a period of inflation and that the collapse from 1929-1933 were a reaction to that. In fact, the 1920s were, if anything, a time of relative deflation: From 1923-1929 – to compare peak years of business cycles and to avoid distortions from cyclical influences – wholesale prices fell at the rate of 1% per year and the stock of money rose at the annual rate of 4% per year, which is roughly the rate required to match expansion of output. The business cycle expansion from 1927-1929 was the first since 1881-1893 during which wholesale prices fell, even if only a trifle, and there has been none since.

“The monetary collapse from 1929-1933 was not an inevitable consequence of what had gone on before. It was the result of the policies followed during those years. As already noted, alternative policies that could have halted the monetary debacle were available throughout those years. Though the Federal Reserve proclaimed that it was following an easy monetary policy, in fact, it followed an exceedingly tight monetary policy.”

The 1920s were, indeed, a period of extraordinary price stability. In particular, under the influence of Milton Friedman, it became axiomatic for American policymakers and economists that the Depression must consequently have had its causes in the policies pursued after the stock market crash. One of the consequences of this generally accepted verdict has been a total lack of interest to probe more deeply into the intricacies of the boom phase. As a result, knowledge about eventual abnormalities during this phase is generally abysmal, even among leading American economists.

Actually, the Fed moved quite fast in light of earlier experience, slashing its discount rate from 6% to 2.5% within one year. The first steep fall of stock prices lasted little more than two weeks, from Oct. 24 to Nov. 13, 1929, from where it sharply recovered until April 1930.

After a pretty stable first half of 1930, during which stock prices rallied strongly, the economy suddenly slumped in the second half, even though the broad money supply had barely budged. To quote Joseph Schumpeter: “Business operations contracted in the midst of a plentiful supply of ‘money.'”

With the euphoria about a “New Era” for the U.S. economy still virulent after the stock market crash, a quick recovery was generally expected. What strikingly differentiated this downturn from all forerunners was the sudden, sharp slump in consumer spending. Yet it was taken for granted that the Fed’s rapid rate cuts would usher in economic revival.

A truly dramatic change in economic activity, and also in expectations, only began with the banking crisis of November-December 1930, acting to reduce the money supply. Escalating bank failures principally had their reason in declining market values of foreign, corporate and real estate bonds ravaging the banks’ capital and lending power. The question is why asset prices fell – because of tight money or due to rising risk premiums as the quality of bonds began to be questioned?

It is the great merit of the proponents of Austrian theory to have uncovered and shown that the borrowing and spending excesses driving a boom may, with or without inflation, exert harmful economic and financial effects other than just a rising inflation rate – actually, more harmful effects.

In the postwar period, recessions in the industrialized countries were sharp and brief until the late 1970s. Limited spending excesses in inventories, business fixed investment, consumer durables and construction were liquidated within barely a year. In the United States, the typical recession for the postwar period has averaged one year, with a decline in real GDP by 2%. As soon as the Fed loosened its shackles, pent-up demand in the areas affected by credit restraint took off again, catapulting the economy to new heights.

Sometime in early 2001, Mr. Greenspan expressed the view that the unfolding recession was of the harmless “garden-variety” type. This used to be the popular label for the short “cyclical” recessions that had been typical of the whole postwar period.

Actually, the U.S. economy’s downturn in 2001 had no relationship or similarity whatsoever to the customary “garden-variety” cycle. Credit growth, far from slowing down, accelerated as never before. An unprecedented slump in business fixed investment, plunging over the following eight quarters by 14.5%, acted as the single depressant.

But sharp increases of other demand components, propelled by prodigious fiscal and monetary stimuli, soon more than offset the slump in business fixed investment. Government spending increased by 9.2% during the same eight quarters. In the private sector, the Fed-engineered housing bubble boosted residential building (+7.2%) and consumer spending (+6%). The net result was America’s shallowest recession, but what followed was the slowest economic recovery in the postwar period. Could there be a connection between the two?

Why the weakest recovery despite the most prodigious policy stimulus in history? If the economy’s downturn was unique in its pattern, so also was the pattern of its upturn.

By the third quarter of 2005, real GDP had grown 14.1% since 2000. It had accrued from disproportionate gains in residential building (+36.5%), consumption (+17.3%) and government spending (+16%). The major adverse counterbalancing forces were sluggish business investment (+5.9%) and soaring imports (+23%).

Over the whole period, real GDP has grown at an annual rate of 2.9%. That is well below the average growth rate of 3.8% for previous postwar business cycles. Outright dramatic is the shortfall in employment and inflation-adjusted income growth. With all the phantom jobs from the “net birth/death,” private sector jobs are just 1% higher than in December 2000, for which employment for defense spending played a significant role. For comparison, payroll jobs in past cycles have risen about 9% over the same time.

Essentially, this dramatic shortfall in employment implies a corresponding shortfall in income growth. During the three months to November 2005, real disposable incomes of private households exceeded their year-ago level by just 1.36%, as against 3.4% for real GDP.

Mr. Greenspan and other Fed members have never made a secret of their systematic efforts to create a panoply of new asset bubbles after the equity bubble popped. Among their policy novelties was the repetitive public assurance to keep their short-term policy rate at a rock-bottom level for as far as the eye can see as incentive for carry trade, particularly for long-term bonds, and as the key condition for inflating asset prices.

Enraptured financial institutions promptly obliged by driving long-term rates and credit spreads to record lows through heavily leveraged carry trade. For the consensus, this represented a highly successful monetary policy that had bowed to no rules.

In hindsight, they hail the many achievements: enormous “wealth creation” through rising house prices, record-high productivity growth, stable and comparatively strong economic growth and the mildest postwar recession in the wake of the bursting equity bubble in 2001.

It makes an impressive list – only a very incomplete one. It ignores a variety of economic and financial inflictions causing and reflecting extremely unbalanced economic growth. This negative list begins with the savings collapse and the monstrous trade gap, and it continues with the housing bubble and the surge of consumption as a share of GDP. Last but not least, it must be taken into account that this subpar economic and income growth has involved an unprecedented credit and debt orgy.


Dr. Kurt Richebächer
for The Daily Reckoning
February 21, 2006

P.S. With the general focus very strongly on the low core inflation rate, Mr. Greenspan earned a reputation for being America’s greatest inflation fighter, which, in turn, is supposed to have laid the foundation for the stellar rate of productivity growth and the extraordinary steadiness of economic growth.

Editor’s Note: Former Fed Chairman Paul Volcker once said: “Sometimes I think that the job of central bankers is to prove Kurt Richebächer wrong.” A regular contributor to The Wall Street Journal, Strategic Investment and several other respected financial publications, Dr. Richebächer’s insightful analysis stems from the Austrian School of economics. France’s Le Figaro magazine has done a feature story on him as “the man who predicted the Asian crisis.”

“A test drive here of the Lifan 520 sedan showed it to have an impressively sturdy body with no rattles or wiggles even when traveling over very rough pavement – although this is no guarantee of long-term reliability. There is ample headroom in the front seats and even the rear seats for a 6-foot-4 occupant.

“The $9,700 price tag includes leather seats, dual air bags, a huge trunk and a DVD system with a video screen facing the front passenger – a combination that could cost twice as much in a comparably equipped midsize sedan in the United States.”

That’s the New York Times describing China’s growing auto industry…another symptom of the relentless Exodus of wealth from the West to the East.

And repeating a comment from yesterday’s Daily Reckoning:

“Mr. Yin has no doubts that China can also compete with the United States.

“Americans work five days a week, we in China work seven days,” he said. “Americans work eight hours a day, and we work 16 hours.”

Given a choice, and all other things being equal, where will the shrewd capitalist decide to put up his factory? Until recently, you see, all other things were not equal. China was a communist country. It wanted nothing to do with capitalists. But now, China is a communist country that wants to get rich. They are laying down the red carpet for capitalists and opening bottles of champagne when they show up.

Americans are so sure that everything is going their way – doesn’t everyone want to be an American-style entrepreneur, they say to each other – they don’t notice that wealth is steadily going the other way, slipping away from them. The triumph of their creed is the defeat of their own selves. In a world of globalized, capitalistic competition, people can’t expect to earn more than the market rate for their labor. A guy in Detroit should earn about the same as a guy in Guangzhou. This is good news to the fellow in Guangzhou; but it will come as bad tidings to the UAW member in the Auto City.

But who cares? How many UAW members are there? It’s a dying industry…yesterday’s enterprise…archaic…antique. It’s the Old Economy. Remember, the buggy industry went out of business, too. We were all better off afterwards. Progress! Creative destruction!

But the destruction of America’s productive industry may not be progress at all. Because America’s factories are not being replaced by new and better industries, the loss is merely disguised by debt and delusions of grandeur.

But don’t worry, dear reader. Congress is on the case. “The U.S. Senate is jumping on board the competitiveness issue,” says a recent headline. Again, Paul Craig Roberts tells the story:

“The Bush regime and the doormat Congress have come together in the belief that the U.S. can keep its edge in science and technology if the federal government spends $9 billion a year to “fund innovative, big-payoff ideas that have the potential to transform the U.S. economy.

“The utter stupidity of the ‘Protecting America’s Competitive Edge Act’ (PACE) is obvious. The tremendous labor cost advantage of doing things abroad will equally apply to any new ‘big-payoff ideas’ as it does to the goods and services currently outsourced. Moreover, U.S. research is open-sourced. It is available to anyone. As the Cox Commission Report made clear, there are a large number of Chinese front companies in the U.S. for the sole purpose of collecting technology. PACE will simply be another U.S. taxpayer subsidy to the rising Asian economies.”

Like the U.S. Empire itself…for isn’t it the American taxpayer who pays to maintain order throughout the world? Isn’t it this order that allows the rapid expansion of the globalized economy? And isn’t it globalized commerce that undermines U.S. wages?

More news from our team at The Rude Awakening…


Steve Sjuggerud reporting from Florida:

“The deal sounds almost irresistible to taxpayers… Not only do you save A$15,000 in taxes, but you also get into an investment that has a good chance of making you money.”

For the rest of this story, and for more market insights, see today’s issue of The Rude Awakening.


Bill Bonner, back in France with more opinions and thoughts:

*** A quick note from Addison…

“Just a head’s up – if you’ve attempted to purchase your copy of Empire of Debt at a 40 percent discount from Barnes and and found that they were sold out, don’t give up. We’ve been assured that they’ll have the book in stock shortly. We’ll keep you posted.”

*** Chickens almost killed us once. Now, we’re keeping an eye on them again.

“Did you see the cranes pass yesterday?” asked Pierre. “They’re doing their annual migration. But this year is different.”

It was a rainy day. We heard the cranes before we saw them. They stopped in the trees beyond the cattle field, taking a break on their long trip. We were outdoors all afternoon, working on a stonewall. Damien, our gardener, was helping. So were Henry and Edward. Henry mixed the mud in a cement mixer attached to the tractor. Edward passed us stones. And even the two boys from across the street, Adrien and Gabriel, came over. They are enjoying a two-week holiday from school, but it is already the second week. They are getting bored. After a moment of gawking, they began picking up rocks, too.

The wall had fallen down decades ago. We are finally rebuilding it, one stone at a time, the way it was put up in the first place. We are reusing the same stones, and laying them down with the same ancient mixture of lime and sand.

But something is different this year. The cranes might be carrying bird flu. The disease has already been discovered in France. Health authorities are taking precautions to stop it from spreading.

“We’re not allowed to let our chickens out,” Pierre explained. “It’s the rule throughout the whole country, I think. All the fowl have to be kept indoors until the migratory season is over.”

What this has to do with our daily economic report, we’re not sure, but yesterday, while the markets were closed in America, life went on. And life comes with hazards…risks…dangers. The cranes that passed over yesterday might have dropped some bird flu virus, which might have been picked up by the ducks on the pond who often fly into our chicken yard to steal food. From there, we don’t know what might happen, but we take for granted that there is only one way out of this life, and the only man who kneweth the hour and place of his exit was probably on death row. For the rest of us, it will have to come as a surprise.

What may also come as a shock is what happens to our wealth. And what is shocking to us here at The Daily Reckoning is how little people seem to worry about it. We think back to our childhood and beyond. When we were about eight years old, as a 4-H project, we raised chickens. A few years later, we were diagnosed with histoplasmosis (a bit like tuberculosis) and is thought to be carried by chickens. Frank Perdue made his fame and fortune by raising the birds in Maryland; we just got sick. Had it not been for the invention of penicillin – which had only come to widespread use about 10 years before – we probably wouldn’t have survived.

Not only was our health precarious, so was our financial situation. Our family had no money. Not that we worried about it excessively, but we were always aware of it. We drank powdered milk and collected soft drink bottles along the roadside in order to return them and claim the deposit. Clothes were passed down from one child to the next, and worn out completely before they were discarded. We didn’t go hungry, but in a large family living on the edge, you didn’t want to get to the dinner table late.

Maybe that childhood experience is why we think of financial risks more than most people do. Not that there’s anything wrong with being poor. We don’t remember being any less happy when we were penniless than when we were flush. But we’ve gotten used to central heating and hot and cold running water. We don’t think we’d like to go back.

*** Every investment comes with a certain amount of risk. Asset prices go up and down. Even the price of gold went down for 20 years. If you’d bought gold in the early ’80s you would have paid as much as $500 an ounce. Thereafter, the price fell in half…until the present bull market began in the early days of the George W. Bush administration.

The safest place for your money is where you don’t have to worry about prices falling. If you buy a house to live in, for example, you may not care whether the price goes up or down; you’re getting your moneys’ worth out of the house itself. That may be true of a business, too. If it provides you with a living and you have no intention of selling, what do you care if it rises or falls in price?

But most people cannot bear to see their investments fall in price. They try to gauge the risk of loss and look for an “upside” that more than offsets the risk. If they are going to make a loan to a desperate company or a shaky country, they want to see enough of a return to make it worth the risk. But the perception of risk is an emotional thing. Sometimes, you see danger everywhere you look – even in the passing of a flock of cranes. And sometimes, you look out your window and see no danger at all.

Today, investors buy Iraqi bonds yielding scarcely more than 7%. Consumers borrow money to buy gadgets from China – running down their savings for the first time since the Great Depression. Speculators buy condos at prices that would have been considered absurd five years ago. Google was still selling for more than $300 a share, last time we checked. No one seems worried about danger: the danger of war, the danger of inflation or the danger of economic setbacks.

Everywhere they look, circa 2006, people must see a world without risk, where all corners have rubber cushions, and where all investments are equipped with airbags.

The Daily Reckoning