DOSE OF RICHEBACHER

BEST OF KURT RICHEBACHER
February 20, 2006
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. As the following table shows, this sudden slump occurred across all demand components. 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?
NO "GARDEN-VARIETY" TYPE
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….
It has always intrigued us how the U.S. economy and its financial system could virtually collapse in the early 1930s if they were in healthy conditions. To explain the rapid collapse with slow rate cuts after 1929 has always struck us as bizarre. For such a collapse to happen, an economy and financial system must have been in terrible shape.
Friedrich Hayek wrote, in Econometrica (April 1934), that the events after 1927 led to the Depression in the United States. The specific events, according to our findings, were the boom-busts of the equity and associated consumption bubbles.
It has been typical of recessions in all industrial countries that consumption has always acted as a stabilizer, while investment and construction turn down. In 1930 and the following years, for the first time, the opposite happened. As the artificial stimulus to consumer spending from the equity boom vanished, slumping consumer spending drastically aggravated the downturn. It is our long-held view that this was one main cause of the Depression’s severity.
The second massive drag came from a highly fragile financial system, which had funded the asset bubble through disproportionately large purchases of corporate bonds, loans on securities and real estate loans.
As asset prices slumped and the economy sharply slowed, the credit pyramid collapsed. It took just three years to wipe out all of the credit inflation of 1922–1929. Total bank loans and the investments of commercial banks at end-1932 stood at a lower figure than during the recession of 1920–21.
WHERE ARE TODAY’S RISKS?
We have recapitulated Japan’s and America’s past disastrous bubble experiences in order to make three things poignantly clear: First, all asset bubbles are the product of credit inflation; second, the two worst bubble experiences in history have developed against the backdrop of virtual price stability; and third, both central banks made their obvious crucial mistake in focusing on low inflation rates and ignoring ongoing credit and asset inflation.
To this, we want finally to add a fourth point: America’s credit inflation since 2000 is the worst in history, as measured by credit growth relative to GDP growth. In essence, the Greenspan Fed replaced the prior bad equity bubble with a much bigger and much worse housing bubble.
The specific effects of credit inflation on the economy and the price system depend on the places where the credit deluge enters the economy. In Japan’s case, it grossly overexpanded construction and business fixed investment. In the U.S. case of the 1920s, it overexpanded consumer spending. Today, the unsustainable excesses are concentrated in consumption and housing.
There is a widespread perception that the U.S. economy under the Greenspan Fed has gained unprecedented steadiness. In actual fact, U.S. economic activity has become dependent as never before on rising house prices facilitating unbridled consumer borrowing. This may temporarily create a semblance of economic stability and strength. The reality is an extremely vulnerable economy and financial system.
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