In this issue I would like to address some of the precursors and consequences to the
existing financial bubble. It is so large that it is often hard to fully grasp, extending not only to
the usual suspects such as stocks, real estate, and corporate bonds, but including a new array of
asset backed securities, GSEs and other investment products that were essentially unheard of
twenty years ago. These new financial creations are in some cases so embedded and intertwined
that even the financial wizards that created them can’t predict what might happen if a principal
player in the system suffers a default. In many ways we are in a new era, but nothing like the one
the bulls are suggesting. It is an era in which international balance of payments are more skewed,
indebtedness is more widespread, notional value on derivatives is higher, and the prospects for
sustained employment are lower than at any time in history.
Many commentators point the finger
of blame when they discuss such issues. I simply don’t think this is realistic. The problems run
much deeper than could ever be solved by tinkering with reserve requirements, central bank rates
and foreign exchange. Many commentators assume that greater fiscal discipline is the answer,
and I will confess it would make my job of prediction much simpler. But it is important to
recognize that such discipline has had its day, and was itself assumed to be one of the main
Unemployed Men During
'Great' Depression
stumbling blocks to recovery from the Great Depression. Subsequent economic theory was
developed in large part as a reaction to what was assumed to be flawed policy. Clearly if such
techniques had been so effective, then an entire army of new economists devoted to greater
monetary ease would never have arisen. Still, it is fair to say that the United States and the rest of
the world have swung so far to the opposite end of the spectrum, into a realm of such vast credit
expansion, lack of regulation and asset inflation, that something rather massive and explosive
has been created. To understand how such a massive agglomeration of debt and intertwined
derivatives became possible, I think it is best to start with a brief history of the international
economic system.
Before Bretton Woods, and before the advent of floating currencies, there was a time
when almost all international transactions were made in gold. This was the era of the classic gold
standard and is a good point of contrast to understand the current system. Under the gold
standard there were inherent limits to the extent to which discrepancies in international trade
could persist. The main reason is that if one country were to consistently export more goods than
it imported, then there would be a net inflow of gold into that country’s financial system, causing
inflation, thereby driving up its prices up with respect to the country which exported less.
Since
all important currencies were fixed to a certain quantity of gold, price increases in one country
translated directly to potential purchasers in another. The more the price inflation endured, the
more expensive its products became, and therefore the more difficult to export. While not
without its problems, this system did have a self-balancing aspect that tended to limit extremes of
current account imbalances.
Under such a system, deflations were a normal, if painful, fact of life. Just as excess
expansion of credit would occur due to a sustained accumulation of gold, so there was the
opposite phenomenon of a contraction of credit due to the loss of such reserves. While it is a
simplification to equate price decreases with deflation, prices do serve as a decent barometer of
monetary contraction. To get some idea of the extent of deflation which was once the norm, I
have plotted a 5 month moving average of annualized consumer price changes in the US between
1913 and 1932. (Strictly speaking the “price” of gold did vary a little during this period, but the
fluctuation was minor with respect to recent history.) As can be seen, there were two periods
during which consumer prices were declining, the most striking of which was the period around
1921 when the decline in the 5 month moving average reached a peak of negative 20%. This
was typical of the era. At the time, deflation was considered normal, and governments usually
devalued only when there was considerable pressure to do so.
