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"Understanding the Great Depression
 & Failures of Modern Economic Policy"
 by Dan Blatt - Publisher of FUTURECASTS online magazine.

 Explaining the Great Depression and failures of "New" Keynesian interest rate suppression policy without ideological clap trap, theory confirmation bias or political spin.

Table of Contents & Introduction
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"Understanding the Economic Basics & Modern Capitalism: Market Mechanisms and Administered Alternatives"
by Dan Blatt - Publisher of FUTURECASTS online magazine.

Smith: Wealth of Nations.   Ricardo: Principles.
Marx: Capital (Das Capital).   Keynes: General Theory.
Schumpeter: Capitalism, Socialism and Democracy.

Economics is the miracle science. Even imperfect capitalist markets routinely raise billions out of poverty.

Table of Contents & Chapter Introductions

Monetary Inflation and Business Cycle Volatility

Market Fundamentalism Has Nothing To Do With It

FUTURECASTS online magazine
www.futurecasts.com
Vol. 12, No. 2, 2/1/10

Homepage

VOLATILITY:

  FUTURECASTS was stressing the acceleration of volatility for several years prior to the Credit Crunch. Did you get the message?
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With monetary inflation and the increasing reliance on debt that inevitably accompanies monetary inflation, instability increases, the business cycle becomes increasingly rapid - and vicious - and private sector employment never rises to prior levels before the next downturn occurs.

  The business cycle continues during periods of monetary inflation. There are both ups and downs. However, with monetary inflation and the increasing reliance on debt that inevitably accompanies monetary inflation, instability increases, the business cycle becomes increasingly rapid - and vicious - and private sector employment never rises to prior levels before the next downturn occurs.
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  These will be the predominant characteristics of the business cycle whenever and as long as monetary policy relies on long periods of artificially low real interest rates.
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  As the Great Deleveraging proceeded during the Credit Crunch, yet another Keynesian stupidity was starkly revealed. Domestic debts are not innocuous. We do not just "owe it to ourselves." Economic and political entities that have become over-reliant on the availability of credit were being rightfully humbled, and many of the private entities thankfully did not survive. Many of the creditors who ignored the obvious financial risks when extending credit failed along with their debtors or took big hits. Some - like the giant government mortgage agencies - were kept on bailout life support as financial zombies, their creditors shielded from the consequences of their foolish actions at taxpayer expense - which may amount to as much as $400 billion. Of course, events have long confirmed that great domestic debts inevitably come to reside increasingly in foreign hands.
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Regulations and government administered alternatives to market mechanisms are simply not adequate substitutes for even imperfect market disciplines.

 

The media are mere conduits for authoritative misinformation.

 

American securities and mortgage markets and its banking industry are among the most heavily regulated in the world, and Congress has for political purposes persistently pursued credit allocation schemes that undermine the credit markets.

 

Cheap money - with interest rates maintained at artificially low levels below market rates - inevitably generates abuses of credit and the creation of financial bubbles.

 

Taxpayer losses on these new subprime low interest rate mortgages must eventually range into the hundreds of billions of dollars.

  Another great failure of government industrial policy has occurred. Regulations and government administered alternatives to market mechanisms are simply not adequate substitutes for even imperfect market disciplines.
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  However, laissez faire market policies are being blamed instead, and an ignorant mass media is as usual acting as a conduit for this misinformation campaign. American securities and mortgage markets and its banking industry are among the most heavily regulated in the world, and Congress has for political purposes persistently pursued credit allocation schemes that undermine the credit market disciplines. Capital adequacy rules of various kinds were inexplicably loosened. Congress, through its tax policies and regulatory bumbling, keeps encouraging debt capital. It increasingly burdens equity capital with high taxes, liability risks, mandates and regulatory burdens, and then expresses shock when the over-leveraged houses of cards come tumbling down and industrial over-expansion renders the economy increasingly unstable.
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  The failure to allow dividends as a deductible expense
for raising and maintaining equity capital - just as interest payments are deductible as an expense of credit capital - powerfully distorts market incentives. This and other tax law stupidities induce pervasive problems with overcapacity and excessive leverage and the destructive emphasis on short term results. The double taxation of dividends is the product of idiotic left wing ideology and causes immense damage.
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  Credit allocation and guarantee schemes
seemed like a marvelous means for achieving political ends without burdening the budget - but there really is no free lunch and now it is the government and its taxpayers who are absorbing much of the vast inevitable losses. These schemes can be traced back to the Community Reinvestment Act of 1977 that required banks to lower their lending standards. Things picked up speed in the 1990s as Fannie Mae and Freddy Mac were driven by their political masters to guarantee a wider range of mortgages. The regulators turned a blind eye to the creative methods that were devised to securitize these dodgy loans so that the loans could be passed on to investors or to off-balance sheet vehicles. Once off the books, even more dodgy mortgages could be provided.
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  Monetary policy remained extraordinarily loose for a long time after the 2001 recession. Cheap money - with interest rates maintained at artificially low levels below market rates - inevitably generates abuses of credit, reckless expansion and the creation of financial bubbles. Investment banks had already responded by changing from partnerships to public companies to offload their risks onto public shareholders. Then they geared up to 20-, 30-, and even 40-to-1 levels in a reckless pursuit of the short term profits that justified the vast earnings and bonuses that made those who had been partners rich. Because of the double taxation of dividends and high marginal tax rates, dividend paying stock that would have aligned executive interests to the long term interests of their corporations was not - and is still not - an attractive alternative.
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  Highly leveraged financial institutions encourage credit bubbles and make the inevitable busts more painful when they begin frantically deleveraging. Things really got rolling a few years ago when Fannie and Freddy began a subprime mortgage buying binge to allocate massive financial resources into "affordable housing." Even now, as financial zombies, they are being kept going to channel hundreds of billions of dollars more into the mortgage market. Even now, as recovery begins, interest rates are being kept extraordinarily low, encouraging the renewed inflation of credit bubbles. Even now, through Ginnie Mae and the Fed, the government is pumping over a trillion dollars into the sub-prime mortgage market at artificially low rates of interest. The losses on these mortgages must eventually range into the hundreds of billions of dollars.
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Vast budget deficits must be monetized by the Fed to keep interest rates from climbing to restrictive levels.

  And it is Congress, as FUTURECASTS has long pointed out, that is driving the monetary inflation that creates this fevered financial environment. Vast budget deficits must be monetized by the Fed to keep interest rates from climbing to restrictive levels. See, "Heedless Government," "Government by Crisis" and "Congress: The Engine of Inflation,"  
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  Ah, but it can all be blamed on "market fundamentalism" and cured with even more government regulation and efforts at market administration by government bureaucrats. Restrictive government regulations inevitably spawn unintended consequences as market participants respond by avoiding or evading or taking advantage. Government guarantees and capital injections inevitably subject the "beneficiaries" to greater political interference. He who takes the King's shilling is subject to the King's whims. Some of the propped up entities indeed survived and regained independence, but others have become financial zombies like AIG, Fannie Mae and Freddy Mac that will continue to absorb economic resources and government funds until they are hopefully finally allowed to die. Industrial dinosaur automobile manufacturers are expected to prosper producing vehicles designed in significant part by Congress. Anybody want to take a bet on that?
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The government role is best directed not in administering market outcomes with guarantees and credit allocations and unfunded mandates that store up problems for the future, but by facilitating market functions.

  Of course, this does not mean that the government has no role to play. However, that role is best directed - as always - not in administering market outcomes with guarantees and credit allocations and unfunded mandates that store up problems for the future, but by facilitating market functions and improving market flexibility. Regulations promoting transparency and standardization of financial products so that they can be traded on exchanges are examples of regulations that can provide major benefits.
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  The "agency problem" caused by the conflicting incentives of ownership and management was recognized by Adam Smith more than two centuries ago but still remains unresolved. However, idiotic tax policies have made this problem much worse. All too often, incentive bonus arrangements provide incentives inimical to the long term interest of the business entity.
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  Requiring that incentive bonuses for top management be limited to restricted stock that cannot be sold or hypothecated for five years after termination of employment further aligns management and shareholder interests, but this is a problem that can at best only be reduced, never eliminated. Reducing high marginal tax rates and ending the ridiculous refusal to recognize dividends as a cost of raising and maintaining equity capital would substantially increase the attractiveness of using dividend paying stock to align executive interests with the long term interests of their corporation. Financial oversight is essential, but is never a match for financial ingenuity and is never an adequate substitute for even imperfect market disciplines..
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The hard economic facts of the business cycle:

  Of course, it was Congress, not Bush, Obama, Greenspan or Bernanke, that was the principle architect of the Credit Crunch, as FUTURECASTS has frequently warned and explained since as early as October of 2002. It is thus well to yet again state some basic truths.

  1. Congress cannot inflate its way out of the problems of inflation. Eventually a painful period of austerity will be forced upon a reluctant Congress to restore the damage caused by the current surge in monetary inflation.
  2. Congress cannot spend its way out of the problems of its deficit spending. Eventually, as in the 1980s and 1990s, even Congress will have to accept restraints on its spending proclivities to restore economic stability and sustainable growth.
  3. Congress cannot deal with credit bubbles by lowering lending standards. Congress should be insisting on sound lending standards instead of restoring credit bubbles, allocating credit, extending guarantees and lowering lending standards for political purposes.
  4. Congress cannot stabilize the economy by encouraging debt financing and discouraging equity financing. Excessive leveraging obviously increases instability. Congress should be encouraging equity capital instead of imposing burdensome taxes, regulations and liability.

  When will Congress launch an investigation into the policies of Congress?

  The limits of Federal Reserve System capabilities are a hard fact that must be kept in mind.

The Federal Reserve System is a creature of Congress, and must serve the political interests of Congress and the administration.

 

Aggressive reliance on monetary inflation to avoid or mitigate recessions MUST ultimately weaken the dollar.

  1. Government deficits do not stimulate the economy. Without the monetization of an appreciable proportion of the debt, the increase in interest rates and the inherent inefficiency of the government activities would be more burden than benefit. Keynesian theory to the contrary is totally invalid and indeed grossly stupid. The Credit Crunch occurred and continues despite vast levels of government budgetary deficits.
  2. The Federal Reserve System is not an independent central bank. It is a creature of Congress, and must serve the political interests of Congress and the administration. It cannot take the responsible but painful measures of austerity to control inflation and maintain the strength of the dollar without political cover from the elected arms of government. It is fear of political backlash - not market fundamentalism - that inhibits disciplined regulatory action against asset inflation and financial bubbles.
  3. Fed monetary policy can only be effective while the dollar is strong. Monetarist views are valid but the potential of monetary manipulation is grossly overstated by the leading proponents. Aggressive reliance on monetary inflation to avoid or mitigate recessions MUST ultimately weaken the dollar.
  4. Fed monetary policy can be no more than a palliative until the fundamental economic and/or political causes of a particular economic contraction are substantially liquidated by the market or politically abandoned. Economists who neglect analysis of such particular problems and limit themselves to the demand problems flowing from fundamental causes are clearly incompetent.

  See the FUTURECASTS book, "Understanding the Great Depression and the Modern Business Cycle."

  The nasty realities of this inflationary period are the same as for all previous inflationary periods. Recessions may occur because of the accumulation of weaknesses in private and/or government management, although it is hard to find a single significant recession where government policy stupidity didn't play a major role. However, all blame for chronic inflation rests with government.

The longer inflation continues, the more painful the austerity policies that will be needed to kick the habit.

  1. Inflation doesn't prevent or mitigate the business cycle. It increases both business cycle volatility and viciousness. Prices can decline during periods of chronic inflation when an inflationary period recession contracts the purchasing power of credit faster than the monetary authority creates additional currency - as occurred during the Credit Crunch. However, price inflation gets worse with each recovery period as long as monetary inflation policies are continued.
  2. Inflation thus causes unemployment. Its ability to reduce unemployment is always temporary, and the period of apparent effectiveness ALWAYS gets progressively shorter. Like an addictive drug, there is always an initial pleasant period that is frequently irresistible to political leaders who are anxious to kick their problems down the road past the next election. Unfortunately, the longer inflation continues, the more painful the austerity policies that will be needed to kick the habit.  The depression of 1980-1982 and a decade of slow growth thereafter was the price that had to be paid to end the Great Inflation decade of the 1970s. See, "Understanding Inflation" and Samuelson, "The Great Inflation." Matters are not yet nearly at that level as of the beginning of 2010, but they could get there very fast.

"Men are not angels!"

  The business cycle and the processes of creative destruction are essential elements of a healthy, growing economic system. Paul Krugman to the contrary notwithstanding, a healthy economic system needs to be able to cleanse itself of weak, outmoded and poorly managed entities, and the flimsy houses of cards inevitably erected during prosperous periods. Governments must be forced to confront the policy stupidities that accumulate over time, and discipline must be imposed on government budgets. Like the political system of the U.S., the economic system must be robust enough to deal with the fact that: "Men are not angels!" (James Madison explaining the need for checks and balances in the Constitution.) See, FUTURECASTS comments in From Keynes to Krugman.

Market flexibility is the only protection against protracted economic disruptions.

  1. Government stabilization efforts that employ Keynesian deficits and/or aggressive monetarist policies MUST make the business cycle worse. Monetary inflation encourages credit bubbles and industrial overcapacity. Government should be facilitating markets, not inhibiting them. Market flexibility is the only protection against protracted economic disruptions. Government should be strengthening the dollar, not undermining it. The government and its monetary authority, the Federal Reserve System, can be no stronger than the dollar.
  2. The right to fail is as important as the opportunity to succeed. A capitalist market economy cannot prosper if heavily burdened with economic dinosaurs and financial zombies that are propped up by government.

Economists who use macro-econometric models might as well be searching for omens in the entrails of a pig.

  Economic projections by government and its economist lackeys are pure fiction and are always biased. The econometric models on which they are based are hopelessly invalid, and the projections seldom survive the next turn in the business cycle. See, Hendry & Ericsson, "Understanding Economic Forecasts." Economists who use these models might as well be searching for omens in the entrails of a pig.

Government needs a mass of credulous people so it can spread the burdens of its stupidity.

  1. Your government will always lie to you about its economic policies and the expectations for success as well as about much else. Government needs a mass of credulous people so it can spread the burdens of its stupidity and enact its unsustainable spending schemes. It must cover the credit bubbles and industrial overcapacity induced by its policies with a smokescreen of obfuscation.
  2. Frequent assurances by government officials and their economist lackeys are a sure warning to check the supplies in the storm cellar.
  3. Private interests and their professional hirelings are frequently no better.
  4. The media is totally lacking in substantive knowledge and so helplessly continues to act as mere conduits for authoritative misinformation.

  Any business or political leader or economist expressing surprise about the Credit Crunch or any other recession is hopelessly incompetent. FUTURECASTS has been warning about the need to be prepared for a continuation of the business cycle with recessions that may be equivalent to 1980-1982 since its very first Near Futurecast on February 1, 1998.

Debt capital has its many uses, but it must rest on a strong foundation of equity capital.

 

"The new inventions in the way of manufacturing credit are seen to have been merely a novel way of repeating the very old practices of abuse of credit."

  1. Heavily indebted business and political entities deserve to fail. Heavily indebted business and political entities are always threatened by any significant recession. FUTURECASTS has for four years been warning about the budget collapse of profligate state governments epitomized by California. No financial entity geared 20-to-1 or 40-to-1 or more can expect to survive a significant downturn in the business cycle. No partnership of substantially wealthy partners would accept such risks. Only when risks are offloaded onto corporate shareholders or the government do we find top management accepting such risk levels. 
  2. Heavy reliance on debt capital is certain to create weakness and instability. There has and always will be those who will succumb to the temptation to abuse credit. There will always be temptations to erect political and business houses of cards. Debt capital has its many uses, but it must rest on a strong foundation of equity capital. There must be substantial "skin in the game." Heavy reliance on debt capital inevitably increases instability and the velocity and viciousness of the business cycle.
  3. On September 15, 1930, the N.Y. Times editorialized: "Everyone recognizes now that this is not a new economic era, in the sense that old-fashioned principles and penalties of economic law have been abolished. The new inventions in the way of manufacturing credit are seen to have been merely a novel way of repeating the very old practices of abuse of credit."

  There will always be "new inventions in the way of manufacturing credit." Some - like the "junk bond" market and collateralized debt obligations - will prove very useful. But like all credit mechanisms, all will be vulnerable to abuse.

  Three of the main themes of FUTURECASTS coverage always bear repeating.

As long as people run towards the dollar during a crisis, the U.S. government will have the strength to deal with it. However, monetary inflation inherently weakens the dollar.

  1. Watch the dollar. As long as people run towards the dollar during a crisis, the U.S. government will have the strength to deal with that crisis. However, monetary inflation inherently weakens the dollar. The Government has a weak dollar policy. Its assertions about a strong dollar policy are an obvious lie. Government loves monetary inflation. Monetary inflation is the easiest tax to impose on the people. By printing or otherwise creating more dollars, government extracts valuable goods and services from the economy in return for nothing more than depreciating fiat currency.
  2. Government management is inherently inept. Moreover, government frequently exhibits a negative learning curve. The more government undertakes, the worse it will perform and the heavier the burden government will impose on the economy. Entitlements are now exhibit "A" for these propositions.
  3. Never underestimate the resiliency, entrepreneurial vigor and innovativeness of the U.S. economy. All it takes for recovery and restoration of normal business cycle levels of stability and prosperity is the restoration of some sanity in government policies involving particularly budget discipline and monetary policy restraint.

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  Copyright 2010 Dan Blatt