The 1990's: Decade of Crises

Most Americans think of the 1990's as a golden age of prosperity that we would love to return to and so it was -- for the United States. For much of the rest of the world, the 1990's were a time rocked by one financial crisis after another, an escalating series of warnings that our financial system was badly out of control. This is one of the areas where Zandi and Krugman complement each other best. Zandi has a chart showing the LIBOR spread (the difference between interest on US treasury bond and loans between major banks), demonstrating how financially turbulent the '90's really were, although his narrative mostly sticks to the 2000's. Krugman describes some of these crises in detail.

The Savings and Loan Crisis: A warning shot across our bow. This one actually began in the 1980's. One of the major reforms of the 1930's was government insurance of deposits in commercial banks (including savings and loans) in exchange for tighter regulation. This reform was highly successful. It stopped bank runs and kept finance on a sound basis up at least until the mid 1970's. Trouble came in the '70's in the form of high inflation. Inflation eroded the value of people's savings, so long as checking accounts were forbidden under Depression-era laws from paying interest. There were no panicked bank runs, but people began more and more moving their money from traditional bank accounts into something that paid interest. The trend accelerated in the early '80's when interest rate skyrocketed. Banks felt a squeeze. Savings and Loans lobbied to be allowed to pay interest to depositors. But this caused a new set of problems, as interest rates on deposits varied, but thrifts kept receiving the same fixed rate on their mortgages. So they pressed (successfully) to be allowed to make higher-risk, higher-return loans. A classic boom and bust followed, with many S&L's taking excessive risks, an epidemic of overbuilding. As required by law, the federal government shut down the involvent thrifts, paid their depositors, and cleaned up the mess they left. The cost was just as much, relative to GDP, as the cost of TARP. Areas where the overbuilding boom was strongest took years to recover. But the damage to the national economy was minimal. Commentators differ on whether the crisis had anything to do with the 1990-91 recession. Even if it did, the recession was a mild one.

Seen from the clear light of hindsight, the Savings and Loan crisis was a clear warning that the general trend toward deregulation sweeping the country should not be extended to finance.

Japan's lost decade. It does not make Zandi's LIBOR chart, but Krugman points out that the Savings and Loan debacle was merely one of many speculative bubbles that formed in the 1980's. Sweden and the other Scandinavian countries had a severe speculative bubble after deregulating banks in the late 1980's and are widely seen as writing the book on how to handle such a crisis. Japan, by contrast, may be seen as writing the book on how not to handle such a crisis. Japan let its bubble build to such extraordinary heights that when it finally deflated, real estate and stock prices fell by 60%. (In our case, the figure is closer to 30%, a somewhat comforting thought). Furthermore, when asset prices fell but debts remained, everyone refused to face what was happening. Banks did not write off bad debts; regulators did not close failed banks. Japan went into a decade of stagnation and deflation. Krugman fears much the same for us today.

Orange County and Baring Bank. Although Krugman does not discuss it, Zandi's chart shows a small blip around 1993 with the Orange County bankruptcy. The timing is odd, since Orange County actually went bankrupt in December, 1994, but the crisis was real and unsettling. Municipal funds are supposed to make only the most conservative investments because taxpayer money is at stake, but conservative, tax-averse Orange County looked the other way as its treasurer made some high-risk, high return investments in derivatives dependent on low short-term interest rates. So long as the investments were successful, Orange County had good services with low taxes and no one asked any questions. Then interest rates went up, the investments failed, and Orange County ended up defaulting on its bonds. About two months later, in February, 1995, England's Barings Bank failed because of a poorly supervised trader's high-risk speculation in derivatives. The story was much the same as in Orange Country; so long as his investments paid off, no one asked whether such high returns were actually a danger sign. Then they failed, taking down more than the bank's available trading capital, and broke the bank.

Mexican and Argentine peso crisis. These financial crises were overshadowed by one that broke in Mexico (and Argentina) in December, 1994. (Clearly the end of 1994 and beginning of 1995 were a bad time for financial crises). To give a brief background, in the 1970's, rising oil prices gave Arab countries more money than they knew what to do with. This money generally ended up in foreign banks, which made large loans, especially to Latin America, without too much thought to countries' ability to repay. Throughout the 1980's, much of Latin America was mired in intractible economic downturn, with living standards declining as debt service ate up more and more of their income. Ultimately, the IMF convinced these countries that the remedy was to fight inflation, cut government spending (especially on any sort of social program) and open up their countries to more foreign trade and investment. For a time, it seemed to work. Argentina stopped inflation by tying the peso to the dollar to prevent the Argentine government from financing by printing press. Mexico let foreign imports and investment flood in. All seemed well, at least to foreign investors.

But troubles were developing just below the surface. Argentina's tying the peso to the dollar left that country at the mercy the dollar's fluctuations and unable to respond when dollars began to withdraw from the country. And Mexico was showing other problems. It developed a huge trade deficit, i.e., shortfall of exports compared to imports, eventually reaching 8% of GDP. How can a country import more than it exports on a sustained basis? How does it finance all those imports. The answer is, by foreign investment. Well, isn't that what developing countries are supposed to want to attract, to make them grow? Yes, but you can get too much of a good thing. Foreign investment tends to be a fickle ally turn against a country on a moment's notice. That was what happened to Mexico in December, 1994. The Mexican peso was overvalued and hurting Mexican exports. But devaluation caused a panic, sent foreign investors fleeing, and threw the economy into a severe downturn.

The Asian Contagion. I remember well that throughout Latin America's debt crisis of the 1980's financial commentators were forever asking Latin American countries why they couldn't be like the rapidly growing Asian countries. If Latin America was seen as the embodiment of vice, Asia was the embodiment of virtue. And then in 1997, something similar struck Asia.

It began in Thailand. Thanks to foreign investment, Thailand was growing rapidly, become one of the Asian exporters. But too much foreign investment was coming in, chasing too few productive outlets. And, as always, this led to asset inflation, i.e. rampant speculation and a bubble. As in Mexico, the trade deficit started growing ominously, reach 6% of GDP, 7% and even 8%. As in Mexico, too many investors were all investing in the same place at once and, as in Mexico, eventually they figured out their mistake and all fled at once. (And, as in Mexico, the triggering event was a devaluation). The financial crisis rapidly spread from Thailand to Malaysia, Indonesia, the Philipinnes, and even South Korea and Hong Kong.

The crisis was blamed in large part on "crony capitalism," the there was also a vague realization at the time that international capital flows were much to blame. Capital flows showed an unfortunate tendancy to turn into capital stampedes, with everyone rushing into the same country at once, and then rushing out again when it appears over-saturated. It the influx had been kept to a manageable level in the first place, capital flight would never have taken place. China largely escaped the contagion because it had capital controls in place, and there was some discussion of whether such controls might be acceptable in general. Krugman heavily emphasizes the Asian crisis in his book, which was originally written shortly afterward.

Long Term Capital Management. I must admit, I had never heard of this 1998 crisis, although it threatened to crash the whole financial system. Krugman's account is harder to follow than most of his book, due to greater use of jargon such as "liquidity and risk premia," "ever narrower profit margins" and "arbitraging away liquidity and risk premia." What I understand him to be saying is this. Riskier investments carry a higher return than safe ones. The reasons are somewhat complex, but the most obvious reason is that investors are normally risk-averse and prefer safer investmensts over riskier ones. So high risk investments have to offer higher returns to persuade people to invest.

Enter hedge funds. Hedge funds have nothing to do with garden stores, and are not even the hedges that mark the outer limits of the finance system. They are so called because they hedge, i.e., limit risk by making contrary investments. (Of course, hedging would also limit returns). They also borrow huge amounts of money compared to original investment, which magnifies both risk and returns. Hedge funds believed that they could cash in on the higher returns of high-risk investments while avoiding actual risk by clever hedging strategies, and thereby have their cake and eat it too. At first it worked, leading to consistently high returns. But in the end you can't have your cake and eat it too. Thinking the risk was eliminated, more and more investors flocked in and more and more hedge funds got in on the act. With more and more people wanting to take on risky investments, the need for higher returns diminished more and more. So hedge funds took greater and greater risks, making investments no sane person would touch with a ten foot pole, and borrowing more and more, assuring themselves all the time that clever hedging strategies were avoiding the risks. But, once again, convincing investors their hedging strategies avoided the risk caused more investors to flock in and returns to diminish. Sooner or later, they were bound to end up in over their heads, taking risks so great no hedging strategy could elminate them.

Eventually they overreached by investing heavily in Russia at a time when Russia was in such complete economic and social breakdown that it did not even have a functioning currency and operated on a barter system. But its stock market was booming, courtesy of insane speculators. Sooner or the Russian stock market had to crash. When it did, people who had lent hedge funds the money they invested in Russia started calling in loans, i.e., the hedge funds suffered a run. To pay their lenders, hedge funds all simultaneously had to sell their high-risk investments that nobody else would touch with a ten-foot pole -- and nobody did. This came perilously close to crashing the whole finance system, but Alan Greenspan cut interest rates, and the panic ceased. In the clear light of hindsight, maybe it would have been less disasterous if the finance system had crashed them, as it became even more perilous in the ten years that followed.

Y2K and the tech bubble. Zandi's chart shows too other financial crises, Y2K (which never amounted to anything) and the bursting of the tech bubble, which did.

And now for the scary part. All these crises were symptoms of a financial system badly out of control, but they all showed it out of control in different ways. The earlier crises, such as the savings and loans, or Japan's lost decade, were the results of conventional banks allowed to run riot. Orange County and the Barings Bank demonstrated the dangers of derivatives. The Latin American and Asian crises showed the dangers of too free and rapid movement of international capital. The LTCM crises showed just how easily hedge funds can crash the whole system. If there is a single theme here, I would say it is the danger of stampedes. Investors can create a bubble in even the soundest investment if they all stampede in at once. And some stampedes are driven by little more than everyone else stampeding somewhere at the same time.

The current financial reform in the process of passing tightens regulations on the largest conventional banks and on derivatives. So far as I can tell, it does nothing to address the dangers of international capital, or of hedge funds, much less of the system's general tendancy to stampede. But only by fighting stampedes can we possibly avert such a crisis in the future.

The Great Depression

Paul Krugman's book frequently refers to the Great Depression but, surprisingly, does not give any extended analysis of it. The Wikipedia offers many alternative explanations, Keynesian, monetarist, Austrian, and debt deflation. To this it adds several less general theories -- income inequality (growth in the 1920's was too skewed toward the top, causing investment to outpace consumption), weakness of the banking system, and the gold standard (countries were forced to protect their supply of gold, regardless of the harm to their domestic economies). What it does not explain is a dirty little secret -- you don't have to choose between these theories. Each theory assumes a single, specific cause, when an epic fail on the scale of the Great Depression is almost always the result of a series of cascading failures. One can quibble about the importance of different factors proposed by different theories but still accept all as at least partially true. So I will recount the Depression freely adopting any of these theories where they work, but with a emphasis on the debt deflation theory, both because it comes closest to popular understanding of the Great Depression, and because of its obvious resonance with today's situation.

Whatever the excesses of the 1920's, the overall prosperity of the era was based on a solid foundation of techological advancement. It was in the 1920's that cars went from a rich man's luxury to something the general public could afford, that movies went from sleazy peep shows for the poor to a major industry and respected art form, that radio and telephones became widely available and commercial broadcasting began, that electricity and running water became universal in urban areas. It was, in short, when the 20th century really established itself. Productivity grew at an extraordinary rate, and major investments transformed the economy and society. But toward the end of the decade, return on actual investments in physical plant began falling. Invariably, this means that investment will fall and a recession will set in.

Why did return on investments fall? The inequality theory holds that growth had been too concentrated at the top, allowing investment to outrun consumption. The Austrian theory holds that credit was too easy, leading to investment at unsustainable rates. Another possibility is that the technological revolution that made the Roaring '20's possible had simply run its course and that a slowdown -- painful, no doubt, but not catastrophic -- was inevitable. Most theories, however, dismiss the falling return on tangible investments as simply another turn of the business cycle that might have led to an ordinary recession if other events had not intervened.

As returns on real investment fell, investors turned to speculation on the stock market. The stock market boom, regarded at the time as a sign of health, was actually an early symptom that the economy was in trouble. As everyone remembers, the stock market was driven to artificial heights by buying on the margin. Investors paying only part of the price of the stock they buy and borrowing the rest from the brokerage firm, to be repaid when the stock is sold, was a well-established practice that continues to this day. In the 1920's the "margin" was 10%, that is, investors could pay only 10% of the price of stock and borrow the rest. It was this practice that drove the stock to such dizzying heights. It was also this practice that might the crash so catastrophic -- suddenly the collateral backing all those debts had lost its value, but the debt remained.

The great amount of bad debt set of a vicious cycle of debt liquidation. Brokers called in loans, which could not be paid. Debtors withdrew money from banks to repay loans, causing banks to lose capital and have to call in loans. As banks came under further pressure, they held more cash and made fewer loans, limiting economic activity for lack of credit, which made more and more borrowers unable to repay. As deflation set in, debts became more onerous, and even debts that had once been good became unsupportable.

Yet the first major bank failure did not occur until over a year after the stock market crash. The New York Bank of the United States failed in December, 1930. The Bank had been involved in stock market trading to an uncertain degree, enough, in any event, to make depositors nervous and start a run. Bank runs proved highly contagious and rapidly spread, to many banks that had nothing to do with the stock market. The contagion was not purely psychological. Many farmers had overborrowed in 1919 when land prices were artificially inflated and long been struggling to keep up their mortgages. Small community banks, with no loans other than to farmers, had also been struggling. The economic downturn caused a drop in commodity prices. Drought further squeezed the farmers and led to a vicious cycle of defaults, foreclosures, and bank runs. This, in turn, led to further deflation, which made more debts bad, which continued the cycle.

But there had been many depressions before. Why was this one so much worse? The usual conservative/libertarian answer is government intervention, and they are essentially correct. In earlier depressions, there had been no central bank, and the federal government made up no more than 2% of the GDP. What this meant was that the federal government could not help in previous depressions, but neither could it harm anything. By the 1930's it had grown greatly in its ability to act for good or for ill, but did not know what it was doing.

In the absence of a central bank, private banks guaranteed each other, acting in concert to bail out any one that came under pressure, let the run prove contagious. (J.P. Morgan could be said to have acted as de facto central banker). The creation of a federal reserve system destroyed private agreements among banks to protect each other, yet the Fed failed to act to stem the spreading bank failures (partly because most of the banks going under were not To Big To Fail). The Fed was also constrained in how much it could do to expand the money supply by limited gold itssupplies. Herbert Hoover was by no means inactive in the face of the Depression, but he largely limited himself to moral suasion. He persuaded a large group of employers to refrain from wage cuts and large-scale layoffs and attempted to persuade banks to protect each other as they had done pre-1913. He also began a public works program, though on a much smaller scale than the New Deal. But he also sought to balance the budget under conditions of disasterously falling revenue, raising the top tax rate from 24% to 63%, which proved ruinous.

So, in effect, libertarians are saying because banks sometimes bailed each other out in the absence of a central bank, but the Fed failed to do so, we are better off without the Fed, and because Hoover's attempts to close the deficit made the Depression worse, we are better off with a government too small to affect anything. This is like observing that a car without a steering wheel will go more or less straight, but steering in the wrong direction is disasterous and therefore urging people to remove their steering wheels as a safety measure.

Franklin D. Roosevelt is also awkward for libertarians because his first term (at least) is characterized by such a rapid improvement in the economic situation. At the time FDR came to power, the finance system was in a state of full-on panic. About half the states had shut down their banks altogether to stop the bank runs, and others were joining fast. The day before he was inaugurated, stock exchanges in New York and Chicago shut down. FDR and Hoover agreed on the need for a national bank holiday, but not the terms. Roosevelt's first act upon becoming President was to declare a "bank holiday" temporarily closing all banks. He then called Congress into session, and they hastily passed the Emergency Banking Act, which allowed the Treasury Department to close down any unsound banks and merge them with sound banks, and the Federal Reserve to make enough loans to sound banks to keep them going. The Act was a stunning success. The bank panic promptly ceased, depositors flocked back to banks to return their deposits, and recovery began. Roosevelt also went off the gold standard to allow the Fed to expand the money supply as needed. So far as I know, even libertarians have a hard time arguing with any of that.

FDR undertook numerous programs, some successful, some not, including public works on a huge scale, the Civilian Conservation Corp, rural electrification, the encouragement of unions, establishment of federal labor law, and the like. Throughout his first term, economic growth was very rapid, although given the depth of the hole the US economy was in, climbing out would necessarily take some time. By 1936, the economy had returned to 1929 levels, although unemployment (always a "lagging indicator," as Ronald Reagan put it) remained high. But there can be no doubt that something went very wrong in 1937. The economy suffered a recession-within-a recovery. Economic activity shrunk rapidly, and unemployment rose dramatically. If the drop had continued another three to four years, it would have been every bit as bad as the 1929-1932 decline. But it did not. The recession reversed after about a year, and recovery began anew.




There is a general consensus that FDR was to blame for the 1937 recession, but disagreement on why. Keynesians blame it on Roosevelt moving prematurely to balance the budget. Monetarists blame it on the Federal Reserve acting prematurely to tighten monetary policy. Business leaders blamed it on anti-business policies including hostile taxes, threats of anti-trust actions, and widespread strikes. Of course, it is entirely possible that all these factors were at work, having a greater effect in combination than any one would have had singly. Empirically, there is no way to tell, because Roosevelt reversed all these policies at once. The economy soon recovered. (Preparations for WWII helped).

So what is a libertarian to do? They have one of two options. Either claim that growth would have been even higher without FDR's policies, or more convincingly blame Hoover's interventioninsm for starting the Depression, then jump ahead to 1937, and airbrush out FDR's embarrassing first term.

American Depressions Before 1929

Before 1929, periodic booms and busts were a regular feature of the economic system. I focus on US booms and busts, not because no one else had them, but simply because the US is the country I know most about.

The panic of 1819. This can be viewed as a ,classic Austrian depression caused by the central bank continuing to spike the punch long after the party got out of hand, a lesson in the danger of slamming on the brakes too fast, or and adjustment to life after the Napoleonic Wars. The US government financed the War of 1812 without a central bank by loans from private banks. Private banks often over-issued currency, leading to out-of-control inflation and speculation. The Second Bank of the US was founded partly to finance government, especially any future wars, and partly to issue a sound common currency. Instead, it encouraged state banks in their lending sprees. People also took advantage of easy credit to buy western land from the government. At the same time, Europe was adjusting to life after the Napoleonic Wars. During the war and in the immediate aftermath, Europeans were importing vast amounts of American farm products and not competing with American industry. As Europe began to recover, its imports dropped and exports grew. The Bank of the US sought to curb inflation by calling in loans and demanding payment in hard currency. Crash ensued, many banks failed, and countless people went bankrupt. Growth resumed in about two years, though effects lingered well into the 1820's.

The panic of 1837. The US government deposited its tax revenues in the Bank of the US and borrowed from the Bank to fund its operations. The Bank also acted as a private bank, making loans to private parties. Andrew Jackson was an inveterate haters of all banks, especially the Bank of the US, in part because of the events of 1819. At the time Jackson became President, the US was running huge surpluses and rapidly paying down the national debt. Jackson resolved to refrain from either spending the surpluses or cutting taxes until the debt was paid off. His goal, in part, was that if the US government no longer had any debts, it would no longer need a bank. The plan succeeded. Jackson paid off the national debt (the only time in US history, and perhaps the only time in the history of any major country). He then vetoed a recharter of the Bank in 1836, withdrew all federal funds, and distributed them among private banks.

Private banks responded with a vast orgy of dubious lending, with rampant inflation and speculation. In effect, Jackson fired the people who take away the punch bowl before the party gets out of hand, raided their liquor cabinet, distributed the contents, and was shocked -- shocked -- when the party got out of hand. His shock was genuine, by the way; Jackson hated speculators as much as he hated banks; indeed, he hated banks for encouraging speculation. He therefore slammed on the brakes, demanding gold and silver for all purchases of federal land. (Selling federally owned western land to private parties was one of the biggest sources of speculation). The country plunged into depression and took six years to recover.

The Long Depression, 1873-1893. Though less steep than the Great Depression, the Long Depression was also world-wide and persistent. Its origins are somewhat mysterious, and there is some dispute whether it was a single depression or a series of recessions. A major cause in the US appears to have been overbuilding of railroads, which had reached its limit. When the Great Northern railway failed, it brought down the Jay Cooke Investment Bank, and panic followed. (Many European countries appear to have had similar overbuilding and crashes in railroads). Tight money policies in the United States and Germany, with a insistence on a gold-only standard also contributed. (This is not a favorite depression among Austrians). French war reparations following the Franco-Prussian War and a wave of international protectionism have also been singled out as contributing factors.

The Panic of 1907. Interestingly, this and not the Great Depression, is the one pre-1990's financial crisis that Paul Krugman's book describes at length. It began when the Knickerbocker Trust (similar to a bank, but not quite the same) lent too much money to a set of speculators trying to corner the market on United Copper Company stock. The effort failed and bankrupted both the speculators and United Copper. This started a run on Knickerbocker Trust and the speculators' banks. Soon panic spread to the other trusts and threatened banks as well. (There was no central bank at the time, but New York banks made some attempts to insure each other. Trusts were not covered by the agreement).

The problem was that J.P. Morgan was out of town that week. As soon as he got back, Morgan (who had already bailed out the US treasury in 1893!) audited threatened institutions and determined which ones were sound. He joined forces with John D. Rockefeller and provided a sufficient infusion of cash to keep the sound banks from failing. He then summoned the presidents of all the city banks to his office and told them the stock market would fail unless they raised $25 million to loan it within 10 minutes. He also directed how this infusion of cash would be used. He followed up by loaning $30 million to New York City to keep it from going bankrupt, buying out a failing brokerage firm, and order the stronger trust companies to put forward $25 million to protect the weaker ones. Finally he persuaded Teddy Roosevelt to waive anti-trust objections -- before the stock exchange re-opened.

If only we had had J.P. Morgan in 2008 to provide $700 billion in TARP money taxpayers would have been off the hook! But that sort of power in a private citizen scares people. Besides, although J.P. Morgan saved the banking system, he did not really save the economy. It had been in decline since before the crisis, and took a turn considerably for the worse after.

It was also this crisis that persuaded the United States that we really needed a central bank. J.P. Morgan was just not an adequate substitute. The Federal Reserve was established in 1913. Many conservative economists blame it for the Great Depression.

Inflation and Speculation

The longest serving chairman of the Federal Reserve was William McChesney Martin, who served from 1951 to 1970 and is famous for his remark that the job of the Fed is to "take away the punch bowl just as the party gets going." Paul Krugman's book comments that this referred more to the Fed's role in fighting inflation than pricking speculative bubbles.

That may be because, although the 1950's and '60's had serious and growing problems with the threat of inflation, they were little troubled by bubbles.* In the 1970's, the Fed tried to stimulate the economy in the wake of oil shocks at the expense of fighting inflation. Inflation escalated throughout that decade, ultimately reaching 13%, but with no sign of a bubble. In the early 1980's, Federal Reserve Chairman Paul Volcker severely tightened the money supply, raising interest rates as high as 20% and throwing the economy into its worst recession since WWII, with unemployment over 10%. In this he succeeded in bringing inflation down to acceptable levels, where it has remained to this day. However, the speculative bubble made a comeback.

In fact, since Volcker broke the inflationary spiral, we have averaged about one bubble a decade, each worse than the one before. In the 1980's Savings and Loans set off a real estate bubble, driving land prices to unsustainable heights and ending in a costly bailout (just as expensive, relative to GDP, as the TARP). Real estate and building had a several-year hangover where the boom was biggest. Opinion is divided on whether the bubble contributed to the 1990-91 recession, and, in any case, it was a mild one. In the 1990's we had a tech stock bubble (Krugman argues that it was a general stock bubble), which burst in 2000, leading to the 2001 recession. That was also a mild one, but recovery was worrisomely slow, and ultimately only came about because of the new housing bubble. That one has proven catastrophic.

Which leads me to an Enlightened Layperson's conjecture that I wish some real economist would address -- that inflation and speculation are really variants on the same thing. Both can come from demand straining against capacity, too much expansion of the money supply, too-easy credit, debt building too quickly, or whatever your theory of the business cycle. The difference is essentially that inflation occurs at the consumption level and speculation occurs at the investment level. Inflation occurs when too much money chases too few goods, i.e., when consumers with too much cash want to buy more than the economy is capable of producing. Speculation occurs when too much money chases too few investment opportunities, i.e., when investors with too many resources want more opportunities to invest than the economy can productively offer. Inflation drives up the price of consumer goods. Speculation drives up the price of investments.

There are also differences between them. Inflation does not appear to have any natural limits. So far the record is held by Hungary, 1945-46, with a inflation that peaked at over 40 quadrillion percent in one month. Speculation, by contrast, does have limits. Speculative bubbles invariably burst, well before they approach some of the more extreme excesses of hyperinflation.** Furthermore, when speculative bubbles burst, asset prices fall, sometimes to more realistic levels, sometimes to serious undervaluation. Halting inflation does not normally mean deflation; it simply means that prices stabilize where they currently are. And finally, although halting inflation is always traumatic to an economy, the prospects for a quick recovery are better than the prospects after a bubble bursts.

I am not suggesting that inflation and speculation are mutually exclusive; it is certainly possible to have both at once. Nor do I claim to know if internationally or over time there has tended to be any trade-off between them. But certainly in the post WWII US, there seems to be a pattern. For three decades, lots of inflation and little bubbling. In the next three decades, low inflation, and one speculative bubble a decade. Without claiming to know why, I could venture a wild guess. From the end of WWII up until the mid-'70's, most economic growth took place among the general public with relatively little at the top. This may have caused consumption to outpace investment and inflation to result. Since the, growth has been concentrated primarily at the top. This may have caused investment to outpace consumption and speculation to result.
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*Confession: This is more a general impression than anything thoroughly researched. I stand ready to be corrected.

**A hyperinflationary bubble could be said to burst when people just stop using the depreciated currency and move directly to barter, so that currency stops circulating altogether. In that case, the hyperinflationary bubble could be said to have burst and given way to hyperdeflation.

The Business Cycle: A Brief Overview

Discussing finance and the economy requires a brief discussion of the business cycle. Roughly speaking, a recession happens when an economy falls below its productive capacity and leaves many resources unused. Inflation occurs when the economy strains against its productive capacity. The study of why the economy falls below or strains against its capacity is called demand-side economics. Supply side is the study of how total economic capacity can be expanded. (It has largely been hijacked since Ronald Reagan's time by people who believe the most effective way to expand total capacity is tax cuts at the top).

The various theories of the business cycle see themselves as rivals, but an Enlightened Layperson can see them, in many ways, as complementary and freely use all of them at once.

Keynesian economics. This was (mostly) what I learned in college. It has the advantage of being the easiest to understand because it ignores finance and focuses entirely on the real (material) economy. The economy is divided into three categories, consumption, investment (defined as actual building, rather than financial investments), and government. Consumption is considered non-problematic. Most people, given money to spend can reliably be counted on to spend (most of) it. The problem is with investment, "a flighty bird" subject to great fluctuations. Furthermore, when investment falls, consumption is imperiled. People lose jobs and income, which causes a reduction in consumption. The loss of consumer spending is a loss of income to businesses, which in turn hire and pay less, and so on down the line. This process is known as the multiplier.

Keynes' remedy for a drop in investment is for government to step in and temporarily take over investment until the private economy recovers. Keynesian economics also favors forms of assistance like unemployment insurance, which blunt the effect of the multiplier by allowing people who lose jobs to cut consumption less.

The concept of a multiplier effect from falling investment is not too controversial, although there is hot debate over how large the multiplier effect is. The more obvious problem with Keynesian economics is that it makes no attempt to explain why investment goes through such wild gyrations. Other economics theories do address that issue, and their answer usually lies with the system of finance.

Monetarism. This theory was developed by libertarian economist Milton Friedman during the 1960's when the Great Depression was a safe distance off and problems with inflation were beginning to ignite. Monetarism sees growth and inflation mostly as products of the money supply. If the money supply grows too quickly, inflation results, and the money supply should be tightened. If the money supply becomes to constricted, it causes recession and the money supply should be expanded.

Everyone understands why printing too much money causes inflation. Buy why does printing too little cause recession? And won't trying to fight recession by printing money just cause more inflation? Well, central banks "print" money by buying treasury bonds from banks and un-print it by selling the bonds back. (Banks apparently do not have the option to refuse). Central banks also lend money to regular banks. The point is that the more money central banks pump into regular banks, the more money banks can lend out to get the economy rolling.

Thus business cycles are caused by either central banks pinching too tight (causing recession) or overdoing it (causing inflation). The remedy is to move in the opposite direction, to tighten the money supply in case of inflation or expand it in case of recession.

But this, too, doesn't really explain how the business cycle gets started. After all business cycles existed without central banks as well. There are two main attempts to address that issue, both sub-categories of the "credit cycle" theory of the business cycle, but with very different perspectives.

Debt-deflation theory: This theory was developed by Irving Fisher during the Great Depression. A growing economy relies on credit and therefore creates debt. When the debt load becomes excessive, people begin paying debts off. But when everyone pays off debt at the same time, economic activity slows and prices fall (because sellers outnumber buyers). Deflation sets in, which makes debts even more onerous, which leads to more attempts to pay them off, and a vicious cycle ensues. Although this theory was long neglected in favor of the views of Keynes and Friedman, it is making a comeback because the current crises looks very much like a debt-deflation cycle at work.

Because of its emphasis on the dangers of deflation, the debt deflation theory is sympathetic to expansionist monetary policy to prevent deflation, or even to inflate one's way out of debt. It is also sympathetic to a Keynesian stimulus; government running up debt to compensate for private parties paying it off.

Austrian theory. Originated by Ludwig von Mises (an Austrian), the Austrian theory of business cycles holds that they are caused by too-easy credit, which leads to careless and bad investments. Eventually the bubble bursts, the bad investments fail, and recession sets in. Given the mess too much easy credit has gotten us into today, all of this is hard to deny. But the Austrian School is regarded by most mainstream economists as a bunch of kooks, although they have many right-wing political followers, including Ron Paul, Glenn Beck, and most of the John Birch society. (Many of my Google searches in researching this post led to Austrian tracts).

So what's wrong with the theory that too-easy credit leads to a dangerous boom-and-bust cycle, given that it is obviously true? For one thing, other theories of the business cycle seek the golden mean. Keynesian economics seeks just the right level of economic activity, that neither strains economic capacity (causing inflation) nor falls below it (causing recession). Monetarism seeks to expand the money supply at the right speed, neither too fast nor too slow. Debt deflation warns against the buildup of excessive debt, but also that running too little debt leads to stagnation. But Austrian economics only warns against the dangers of too-easy credit and never considers the possibility that too-tight credit might also cause problems.

This leads to bizarre consequences. For one thing, Austrians do not accept easy money policies as a way of relieving a recession. Even in the depths of the bust, their first fear is re-igniting the boom. Another is that they do not accept any sort of intervention at all as appropriate. Recessions, even depressions, are not seen as a problem, just a flushing-out of bad investments. Only the boom that preceeds the bust is a problem.

It also leads to some extreme suggestions on how to prevent the boom-and-bust cycle. All involve abandoning central banking and the entire modern system of finance. And by the modern system of finance, I mean not just the fancy financial instruments that caused the current crash, but banks and paper money altogether. All want to return to the gold standard, allowing government to issue only gold coins as money. Some want an unregulated system of banks, with each bank free to issue its own gold certificates (bank notes). Of course, we had just such a system from 1837 to 1913. The result was that banks frequently over-issued notes and loans leading to too-easy credit and exactly the boom-and-bust cycle the Austrians predict.

Some therefore respond by proposing to abolish banks altogether, or rather, to allow banks as vaults for storing money, but forbid them from lending it out. So where would credit come from? Well, people would be perfectly free to lend their own money, just not anyone else's. Home purchases would presumably be financed by direct installments to the seller, corporations by bonds and -- well, I don't know enough about modern finance to understand the full implications, but I could say this much with confidence. Such a system would, indeed, eliminate any problems caused by too-easy credit. But the Austrians really need to think of the dangers of too-tight credit strangling an economy to death. We are dealing with them now.

Bad Blogging Habit, Continued

This post has an interesting analysis of the problems in our finance system. In effect, fiancial institutions are driven, less by what investors want than by what generates the most volume of trades because that is where the money is. In other words, we have a system of Paganini finance.

That would explain a lot!

Finance: Some Very Basic Concepts

Part of struggling to understand what the financial crisis and financial reform are about includes struggling to understand the terminology. And not just complex and technical jargon, but basic concepts like a "bank." What is a bank, exactly? The most obvious answer is it's where you park your money to keep it safe, the the answer is more complex than that. Are Savings and Loans banks? What about credit unions? What about investments banks, which have the word "bank" in their name, but don't take deposits at all?


Paul Krugman offered a rough definition of banking in his book. A bank is an institution that borrows money to invest. Specifically, it promises its lenders that they can cash out fast, while making investments that are not easily liquidated. Such an arrangement is inherently unstable -- if too many lenders want to cash out at once, the bank cannot liquidate its investments fast enough to satisfy all of them. Panic and a bank run ensue. Since the experts don't agree on which financial institutions should or should not be called "banks," I will just refer to any institution that borrows to invest as a financial institution and refer to the ones that take deposits as commercial banks (a term sometimes used to distinguish them from investment banks).


This led to the next very elementary question -- what is the difference between a lender and an investor. The distinction is straightforward enough at your neighborhood commercial bank, but it becomes less clear as you move deeper into the realm of high finance. Basically, though, a lender gives a financial institution money with a clear, contractual right to repayment on pre-determined terms that are independent of the institution's fortunes. In other words, a lender (in theory, at least) gets no less if the borrower is doing poorly and no more if the borrower is doing well. Investors, in effect, get what is left when borrowers are paid off, but they have no right to any specific amount. Investors reap the profits in good times and bear the losses in bad times. If the institution fails, lenders recover what they can in bankruptcy proceedings, and investors get nothing at all. Investors, in short, are the ones who bear the risks.

For a commercial bank the distinction is obvious. Depositors are the lenders. A bank account is, in effect, a loan to the bank that can be called in at any time, in whole or in any part. A bank account is listed on the bank's balance sheet as a liability because the depositor can withdraw or close it any time, although the cash in the account is, of course, an asset.

In an insurance company, policy holders are lenders who can call in their loans only if they have a misfortune.

In a non-financial corporation, stockholders are investors and bond holders are lenders. Bonds pay interest on pre-determined terms. Stocks pay dividends that depend entirely on the profitability of the corporation.

And then there is high finance. Most accounts of high finance focus on the sorts of investments they make -- complex and risky investments that commercial banks are barred from making. What I am still struggling to understand is where high finance gets its funding, i.e., who it borrows from to make its investments. The answer (so far as I can tell) is that various high finance institutions borrow from each other, sort of like taking in each other's wash.

Again, I understand what happens when there is a run on a commercial bank. Depositors all want their money back at the same time. The bank doesn't have (most of) it in the vault and can only pay a few of them. The bank fails. Most of the depositors lose their money. The bank is no longer available to make loans. (And, although this does not get so much attention, presumably anyone who owes the bank is off the hook). Worse still, a single bank run can lead to a run of runs. The damage to the larger economy can be devastating. Recessions can come from many causes, but, so far as I can tell, true depressions come from some sort of malfunction in the finance system.

It was to prevent such an outcome that deposit insurance was instituted, and it was highly successful. Runs on commercial banks ceased. The industrial world, at least, stopped having depressions, and until the current crisis, even threats of depression. But, as I understand it, in the latest crisis a series of non-depository financial institutions suffered runs as their lenders (known as counterparties) all started calling loans at the same time.

What I am still struggling to understand is who those counterparties were, and what happens to the finance system when high finance institutions suffer runs.

Banking Reform: A Personal Comment

The Senate and House are now about to hold a conference committee to reconcile their respective versions of the banking reform bill. I want to post on the subject before it is too late.

But first, let me be clear. I do not understand finance. I have never understood finance. Since the 2008 crash, I have been struggling mightily to wrap my head around the subject, making progress, but only beginning to understand how little I know. In college, I took some basic undergraduate courses in economics and attempted a paper on the IMF, but whenever our economics courses made the most elementary discussion of finance, my mind went blank. Yet finance is a very important subject. Most of our economic disturbances, and certainly the major ones, are the result of something going wrong in the finance system.

2008 was both the year our financial system went off a cliff and the year I started law school. In 2005-2006 I started learning the joys of net surfing on the job. Occasionally an article would pop up warning that we were in a huge real estate bubble and no one knew what would happen when it burst. I didn't understand the stories and mostly ignored them. In 2007, I came into some money and asked a realtor about buying a house. She said better buy now, because housing prices were about to crash. In my innocence, I thought good, I'll wait till housing prices crash and then buy cheap. (Besided, I was about to start law school and not have an income, which made buying a house just then seem like a really bad idea. Which means I know more about finance than a lot of mortgage originators, apparently).

Over the summer of 2008, gas prices soared to $4.00 at the pump, food prices went up, and bad news rained in from all sides. At that time I commented that we seemed to be facing stagflation for the first time since the 1970's and that the accepted remedy was for the Federal Reserve to tighten the money supply, raise interest rates, and induce a recession to squeeze inflation out of the system. But the finance system was healthy last time and could withstand the strain. In 2008 I had my doubts. It was a foolish concern. What I should have remembered is that if your goal is to induce a recession to squeeze out inflation, an unhealthy finance sector is more than capable of doing the job without any help from the Fed.

In August, 2008, I started law school. In September, all hell broke loose in the financial system. Everywhere, articles popped up trying to explain what was happening that I couldn't make heads or tails of. People were talking about asset-backed securities, LIBOR spreads and the relative merits of mark-to-market and mark-to-model accounting. I didn't know a hedge fund from a line of credit at a garden store or the LIBOR spread from an exotic brand of mustard. Articles attempting to explain what was going on mostly confused. (Someone who worked in the finance industry was quoted as saying that the problem with most articles in the popular press was that they needed to be about four times as long to even begin to explain what was happening).

So I went to Borders to look for a book explaining it. Most of what they had were either investment books on how to make money in the crash (which assumed much greater financial sophistication than I had), books with detailed explanations of some sub-part (which also assumed greater sophistication than I had and left large areas unexplained) or books advocating a certain course of action (all of which had some sort of ideological axe to grind). What I wanted was something entitled Sub-Prime Crisis for Dummies or The Complete Idiot's Guide to the Financial Crisis. There was no such book. The best alternative I could find was Financial Shock by Mark Zandi. Zandi is an economist for Moody's ratings who served (as it would turn out) as a financial advisor for the McCain campaign and for the Obama Administration. His book had blurbs from everyone from Lawrence Kudlow to Barney Frank. So it did not look like the work of anyone with an ideological agenda. It described the sub-prime crisis and the workings of the finance system as an insider, explaining the system to outsiders. It made what was going on comprehensible (though still rather dry and technical). It had two major shortcomings. First, it focused too much on the financial crisis as a crisis of sub-prime mortgages, rather than a general crisis in the financial system (although it moved more toward that later on). Second, and more seriously, it was written in summer of 2008, at which time the author could say that the worst seemed to be over. Little did he know everything up till then was just a preview for coming attractions! (He has since corrected that shortcoming with an updated edition).

I spent Christmas Break of 2008-2009 visiting my parents and reading Financial Shock. My mother commented that it looked dull and technical and bought me Paul Krugman's The Return of Depression Economics. Depression Economics has less depth than Financial Shock, but more breadth. It does not have much description of the inner workings of high finance, or much technical explanation of all the complex financial instruments that brought the system down. But it has a longer-term and more international focus, looking in particular at international currency crises in 1990. In this (as in some other things), the books reinforce each other. Zandi has a chart of the LIBOR spread, which is not an exotic mustard, but the spread in interest rates between US Treasury bonds and loans between major banks. The spread goes up in financial crises, when banks become nervous about lending to each other. Both books demonstrate that the 1990's, which Americans think of as a golden age of prosperity, was in fact a time rocked by constant financial crises, all of which should have warned us that our finance system was running badly out of control. I also read the mid 1990's book, When Corporations Rule the World, particuarly its section on finance, warning about the dangers of an out-of-control finance system, citing many of the same incidents that Krugman mentions and that show up on the LIBOR chart.

Finally, as the Senate debated financial reform, I read up on it on internet sites, from Wikipedia, to serious geek sites, trying to drive these complex and technical concepts into my head. It got so bad that I would read the sites late into the night and go to bed with financial information whirling in my head. In the morning I would be wakened by my cat, crying to be fed, and mistake him for a bank, crying to be deregulated! (Upon waking up further, I would realize that a cat just wants food and doesn't know about banks at all. Lucky cat!)

So, despite still not understanding finance, despite knowing no more about it than an Enlightened Layperson who has done some desparate cramming, I will, nonetheless, presume to do a series of posts on finance and banking reform. I hope to follow (and be influenced by) Krugman, taking a historical approach through past financial crises, up to the Great Depression, the 1990's, the present, and a mighty attempt to understand what Congress is debating.

Wish me luck!

One Final Comment on Healthcare

Healthcare reform has largely dropped out of the news since passing. Although I believed that as a political matter, it should have been made to vest, there was one potential policy advantage in waiting till 2014.

People like Sarah Palin and Michelle Bachman insist that it will lead to death panels in the sense that if everyone has access to healthcare, it will have to be rationed and people will be denied essential services. The obvious retort is that if some people don't have access to healthcare at all, they are by definition being denied essential services. In effect, what Palin and Bachman are saying is don't let anyone else get access because it will take services from me. Not a very edifying argument, but one with a certain appeal.

But is it true? For life-threatening conditions or serious illness, no. We already have mechanisms in place to ensure that no one is left to die in the street. Most of the uninsured entering the system will be reasonably healthy. But what the Massachusetts experience has shown is that, although critical care will not be much affected, primary care will be severely strained. The influx of 32 million people, fairly healthy, but without regular care up till then, will be a serious strain on our primary care system.

That is the advantage of a four-year lag. It will give us time to prepare by training a large number of primary care providers to cope with this sudden influx. We should be working on that between now and then. For instance, we should vastly increase scholarships to become nurse practitioners and physician assistants. (These two categories are qualified to give primary care to a generally healthy person, but they are less expensive and quicker to train than family doctors). We should be advertising, urging people to follow these two careers because they will be growth industries in a few years. And if we are unable to train enough primary care providers on our own, we should start admitting more immigrants who can offer primary care.

So, what are we doing now to prepare for the influx? So far as I can tell, nothing.

Obligatory Oil Spill Post

So, what should Obama do about the oil spill? I fully agree with people who say that getting mad and pounding the table seems pretty pointless. I never agreed with the people who said that jihadi attacks are happening because Obama isn't belligerent enough in his speeches, but at least jihadis are human actors who might conceivably respond to that sort of thing. Oil is not. Oil will keep gushing out without the slightest regard to whether the President of the US loses his temper. (And British Petroleum doesn't like the situation any more than anyone else. They aren't delaying in blocking the leak because the President isn't angry enough at them).

At the same time, I do think his response has been lacking. So here is my suggestion. Pretend it is an earthquake in Haiti. There seems to be a general consensus that Obama's response to the Haitian earthquake was all one could ask for. So why not duplicate it here in the US? Leave plugging the leak to BP, but go all out in cleaning up the slick. (This column goes so far as to suggest making it the new Civilian Conservation Corp). Publicize the all-out you are doing to clean up the spill. Unveil a generous plan to help the Gulf Coast states recover from the impact. (If it causes embarrassment in people opposed to all government spending, but eager to benefit from it, so much the better).

But there's more than that. One of the frustrating things about the spill has been our sense of helplessness. Americans may hate relying on government, rather than ourselves. But, as the spill makes clear, it turns out that, after all, Americans would rather rely on government than on British Petroleum. At least the President is someone we elect and feel we can, to some degree, hold accountable. (And even people who didn't vote for the man and hate his guts can still hope to impose some accountability on the office). But really, what people want most of all in a crisis like this is to get past this sense of helplessness and be about to do something about it. So give us something to do. What charities are available to clean up a mess like this? Tell us who they are and where we can donate. Is anyone taking volunteers? How about giving a shout-out to former Presidents Clinton and Bush for their good work raising funds for Haiti and asking them to do the same for the Gulf Coast? Or mobilizing that network of supporters to help in the clean up?

A local newspaper article discussed barber shops and beauty shops collecting hair and old nylons to make oil booms. Well what about it? Why not urge hair cutting places to donate their hair for oil booms and urge everyone to go out and get a haircut? Better, get your own hair cut (okay, there isn't much of it) and donate the clippings along with Michelle's old nylons. Or, better yet, see if Michelle and the girls will get their hair cut, too. Best of all, stage a photo op with all the Gulf Coast state governors getting all your hair cut. (This is the sort of thing where dislike of the man can give way to respect for the office. My hair is joining presidential hair in stopping the oil slick!)

As for anger, I will admit, I don't live on the Gulf Coast, and maybe if I did, I would feel different. But as it is, I am inclined to see this anger mostly as frustration that will dissipate if given a creative outlet. And I can't muster any desire to punish British Petroleum. Nothing government does to BP could possibly be as bad as what nature is doing to them every single day.

I Don't Get It

Seriously. When did even the slightest deviation from the Israeli line become a radical, unthinkable policy for a US President to pursue? It wasn't always like that.

Truman had grave misgivings whether to recognize Israel at all.

Eisenhower was furious when Israel, Britain and France invaded the Sinai, condemned their actions at the United Nations, and put strong pressure on them to withdraw.

Nixon send Kissinger to mediate a cease-fire between Israel and the Arab governments in the Yom Kippur War.

Carter mediated a peace treaty between Israel and Egypt.

Reagan opposed Israel's invasion of Lebanon, made an effort to restrain Israel, and negotiated the withdrawal of the PLO.

Clinton mediated an agreement between Israel and the Palestinian Authority.

The roles of mediator and marionette are incompatible. It is impossible to be perceived as an honest broker if you make it a policy to automatically rubber stamp everything one party wants or does.

I can only conclude from this that our relationship with Israel moved from ally to poodleduring the presidency of G.W. Bush. Up till then, the belief that our only proper association with Israel was one of unconditional obedience was one policy viewpoint, and not such an uncommon one. But it was not the only one to hold any sway in serious policy circles. But G.W. Bush adopted a clear policy -- we would be Israel's poodle, and everyone else was expected to be our poodle.

Now Obama is making some feeble, half-hearted steps from poodle back to ally and everyone who is anyone is throwing a collective fit at his radical, unheard-of actions.

Tea Parties: Two Attempts at Analysis

There is a certain bizarre unreality to the the Tea Party movement. Here we are, in the midst of the worst economic downturn since the Great Depression, and enraged demonstrators are out in the street, demanding that we adopt the policies of Herbert Hoover. Jacob Weisberg at Slate doesn't think this is so strange. The Tea Parties are just typical Western libertarian conservatives, expressing their "opposition to any expanded role for government, whether in promoting economic recovery, extending health care coverage, or regulating financial markets."

I find this argument unconvincing for two reasons. First of all, does Weisberg really believe that if the government had adopted the policies of Hoover, allowed the financial system to crash, cut spending when most needed and (some even propose) refused to expand monetary policy, that Tea Partiers would be pleased with these developments? As we sunk into depression, would they be proclaiming how happy they were that the government was off their back and letting them starve in peace? Pardon my skepticism. The other reason is the demographics of the movement. Tea Partiers tend (with many exceptions) to be older -- some already receiving Social Security and Medicare, others anticipating receiving them within the next ten years. Why is rage over government spending strongest in the age group that most benefits from it? Do they want their Social Security and Medicare cut off?

Assuming the answer in both cases is no, I see two other answers to who the Tea Partiers are and why they are so upset over government spending.

One explanation is economic. They are of an age group that receives or will soon receive Social Security and Medicare. They also know that these programs will come under increasing strain in the near future as our population over 65 swells. They therefore fear government taking on any more obligations lest it threaten obligations to them. Seen from this perspective, their opposition to (any more) government spending is perfectly rational. I do wish they'd be more honest about it, though.

The other explanation about the Tea Party movement is that is is first and foremost about culture. The problem is not the amount of taxes (which have not, in fact, increased), or the amount of spending (deficits, after all, started ballooning as soon as the financial crisis hit, but they didn't seem too concerned so long as Bush was in power). It is not even what the money is being spent on. The real question is who is spending it.

By this view, Tea Partiers see their own culture, authentic Real American culture, under siege by a mocking liberal elite that has no respect for their values and no reverence for the things they hold dear. This is not an unreasonable complaint. Modern liberals do mock and look down on a lot of what might be considered traditional American culture and values. Preaching tolerance and cultural relativism, too often they are willing to extend it to everyone except our own. The Democratic Party represents this liberal elite -- as well as Spanish speaking immigrants, Muslims, and really anyone outside the Real American consensus. The real problem with government spending is not that it is too great, or that it is driving taxes too high, or even that it is going to unworthy people, but that the inauthentic, un-American Democrats are in charge of it. And, when you get right down to it, the real problem with government in the first place is that it sometimes falls into the hands of Democrats.