Cause of the Great Depression

P8475423 at vmsuser.acsu.unsw.EDU.AU P8475423 at vmsuser.acsu.unsw.EDU.AU
Wed Sep 20 16:55:39 MDT 1995


Now here's a point where I *do* part company with Chris S:

|        Welfare was created to keep the poor in their place because the
|social economy of the early 20th century was careening from one statist
|crisis to another, smashing up in the Great Depression which was caused
|by Federal Reserve monetary manipulation...

This interpretation of the Great Depression is one that both Austrian
and neoclassical economists (with Friedman the arch example) have
promulgated. It is one rejected by Post Keynesian economists (and
Marxian, though for different reasons). PKs tend to see it as the
product of a debt deflation following a debt-financed boom (though I
know Austrians have some sympathy with the final part of this statement),
and the crash would have happened no matter what the Federal Reserve
did--though what the FR did do may well have made the crash worse.

In my opinion, Minsky's "financial instability hypothesis" gives the
best explanation of the mechanism behind such a collapse, and for those
that are interested, I have posted an excerpt from my JPKE paper where
I summarize that theory at the end of this post. For Jerry's interest,
the paper itself models that process using a nonlinear system.

I don't disagree hugely with what Chris then led on to:

|Corporations and unions JOINED
|FDR in creating the original New Deal corporate state modelled on
|Mussolini's Italy.  Welfare was part of this corporativist structure, as
|it was for Bismark.  If it helps the poor from starving, it also helps
|the rich keep the poor from fully grasping the system that created
|poverty.  The social democrats who provided the rich with an ideology of
|altruism to help the poor may not have known that that ideology would be
|used in such an insidious way, but thems the facts.

But I would argue that such mechanisms are a vital, non-market
"homeostatic" input, without which capitalism would lurch into many more
Great Depressions, no matter who was running the federal reserve.

Finally, a bit of decent statistics I've recently found. In a paper
entitled "Business Cycles, Real facts and a monetary myth", the authors
argue:

"There is no evidence that either the monetary base or M1 leads the
cycle, although some economists still believe this monetary myth.
Both the monetary base and M1 series are generally procyclical, and,
if anything, the monetary base lags the cycle slightly."

"An exception to this rule occurred during the expansion of the
1980s... During the expansion, M1 was uncommonly volatile, and M2,
the more comprehensive measure of the money stock, showed some
evidence that it leads the cycle by a couple of quarters."

"The difference in the behaviour of M1 and M2 suggests that the
difference of these aggregates (m2 minus M1) should be considered.
.. The difference ... leads the cycle by even more than M2 ..."

"... it is also apparent that money velocities are procyclical
and quite volatile."

To summarize the implications of the above, it implies that
the money supply is endogenous--and that therefore,
manipulation of the money supply as a means to control the
economy (whether for good or ill, such as causing the GD)
is difficult, if not impossible. It also implies that
endogenous credit cycles may well drive the trade cycle,
a view that is consonant with Minsky's hypothesis.

Cheers,
Steve Keen

Kydland FE & Prescott EC, "Business Cycles, Real facts
and a monetary myth", Federal Reserve Bank of Minneapolis
Quarterly Review, 1990, pp. 3-18

Minsky excerpt:

Minskys analysis of a financial cycle begins at a time when the economy
is doing well (the rate of economic growth equals or exceeds that needed
to reduce unemployment), but firms are conservative in their portfolio
management (debt to equity ratios are low and profit to interest cover is
high), and this conservatism is shared by banks, who are only willing to
fund cash-flow shortfalls or low-risk investments. The cause of this high
and universally practised risk aversion is the memory of a not too distant
system-wide financial failure, when many investment projects foundered,
many firms could not finance their borrowings, and many banks had to write
off bad debts. Because of this recent experience, both sides of the
borrowing relationship prefer extremely conservative estimates of
prospective cash flows: their risk premiums are very high.

However, the combination of a growing economy and conservatively financed
investment means that most projects succeed. Two things gradually become
evident to managers and bankers: "Existing debts are easily validated and
units that were heavily in debt prospered: it pays to lever." (Minsky
1982, p. 65). As a result, both managers and bankers come to regard the
previously accepted risk premium as excessive. Investment projects are
evaluated using less conservative estimates of prospective cash flows, so
that with these rising expectations go rising investment and asset prices.
The general decline in risk aversion thus sets off both growth in
investment and exponential growth in the price level of assets, which is
the foundation both of the boom and its eventual collapse.

More external finance is needed to fund the increased level of investment
and the speculative purchase of assets, and these external funds are
forthcoming because the banking sector shares the increased optimism of
investors (Minsky 1980, p. 121). The accepted debt to equity ratio rises,
liquidity decreases, and the growth of credit accelerates.

This marks the beginning of what Minsky calls "the euphoric economy"
(Minsky 1980, pp. 120-124.), where both lenders and borrowers believe that
the future is assured, and therefore that most investments will succeed.
Asset prices are revalued upward as previous valuations are perceived to
be based on mistakenly conservative grounds. Highly liquid, low-yielding
financial instruments are devalued, leading to a rise in the interest
rates offered by them as their purveyors fight to retain market share.

Financial institutions now accept liability structures both for themselves
and their customers "that, in a more sober expectational climate, they
would have rejected" (Minsky 1980, p. 123.). The liquidity of firms is
simultaneously reduced by the rise in debt to equity ratios, making firms
more susceptible to increased interest rates. The general decrease in
liquidity and the rise in interest paid on highly liquid instruments
triggers a market-based increase in the interest rate, even without any
attempt by monetary authorities to control the boom. However the increased
cost of credit does little to temper the boom, since anticipated yields
from speculative investments normally far exceed prevailing interest
rates, leading to a decline in the elasticity of demand for credit with
respect to interest rates.

The condition of euphoria also permits the development of an important
actor in Minskys drama, the Ponzi financier (Minsky 1982, pp. 70, 115;
Galbraith 1954, pp. 4-5). These capitalists profit by trading assets on a
rising market, and incur significant debt in the process. The servicing
costs for Ponzi debtors exceed the cash flows of the businesses they own,
but the capital appreciation they anticipate far exceeds the interest
bill. They therefore play an important role in pushing up the market
interest rate, and an equally important role in increasing the fragility
of the system to a reversal in the growth of asset values.

Rising interest rates and increasing debt to equity ratios eventually
affect the viability of many business activities, reducing the interest
rate cover, turning projects which were originally conservatively funded
into speculative ones, and making ones which were speculative "Ponzi".
Such businesses will find themselves having to sell assets to finance
their debt servicingand this entry of new sellers into the market for
assets pricks the exponential growth of asset prices. With the price boom
checked, Ponzi financiers now find themselves with assets which can no
longer be traded at a profit, and levels of debt which cannot be serviced
from the cash flows of the businesses they now control. Banks which
financed these assets purchases now find that their leading customers can
no longer pay their debtsand this realisation leads initially to a
further bank-driven increase in interest rates. Liquidity is suddenly much
more highly prized, holders of illiquid assets attempt to sell them in
return for liquidity. The asset market becomes flooded and the euphoria
becomes a panic, the boom becomes a slump.

As the boom collapses, the fundamental problem facing the economy is one
of excessive divergence between the debts incurred to purchase assets, and
the cash flows generated by themwith those cash flows depending both upon
the level of investment and the rate of inflation. The level of investment
has collapsed in the aftermath of the boom, leaving only two forces which
can bring asset prices and cash flows back into harmony: asset price
deflation, or current price inflation. This dilemma is the foundation of
Minskys iconoclastic perception of the role of inflation, and his
explanation for the stagflation of the 70s and early 80s.

Minsky argues that if the rate of inflation is high at the time of the
crisis, then though the collapse of the boom causes investment to slump
and economic growth to falter, rising cash flows rapidly enable the
repayment of debt incurred during the boom. The economy can thus emerge
from the crisis with diminished growth and high inflation, but few
bankruptcies and a sustained decrease in liquidity. Thus though this
course involves the twin "bads" of inflation and initially low growth, it
is a self-correcting mechanism in that a prolonged slump is avoided.
However the conditions are soon re-established for the cycle to repeat
itself, and the avoidance of a true calamity is likely to lead to a
secular decrease in liquidity preference.

If the rate of inflation is low at the time of the crisis, then cash flows
will remain inadequate relative to the debt structures in place. Firms
whose interest bills exceed their cash flows will be forced to undertake
extreme measures: they will have to sell assets, attempt to increase their
cash flows (at the expense of their competitors) by cutting their margins,
or go bankrupt. In contrast to the inflationary course, all three classes
of action tend to further depress the current price level, thus at least
partially exacerbating the original imbalance. The asset price deflation
route is, therefore, not self-correcting but rather self-reinforcing, and
is Minskys explanation of a depression.

The above sketch basically describes Minskys perception of an economy in
the absence of a government sector. With big government, the picture
changes in two ways, because of fiscal deficits and Reserve Bank
interventions. With a developed social security system, the collapse in
cash flows which occurs when a boom becomes a panic will be at least
partly ameliorated by a rise in government spending--the classic
automatic stabilisers", though this time seen in a more monetary light.
The collapse in credit can also be tempered or even reversed by rapid
action by the Reserve Bank to increase liquidity. With both these forces
operating in all Western economies since WWII, Minsky expected the
conventional cycle to be marked by "chronic and ... accelerating
inflation" (Minsky 1982, p. 85). However, by the end of the 1980s, the
cost pressures which coincided with the slump of the early 70s had long
since been eliminated, by 15 years of high unemployment and the diminution
of OPECs cartel power. The crisis of the late 80s thus occurred in a
milieu of low inflation, raising the spectre of a debt deflation.


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