A number of misconceptions seem to be swirling about the financial crisis. In particular, commentators from many corners are making comparisons between the US and Japan, and this crisis to the Great Depression. There are some parallels in both cases, but there are some differences that are important enough that I do not think we should expect anything even close to an exact replay in either case.
I'll do a sort of compare-contrast of each to show why I think this is the case.
Japan vs. The US
There are three significant differences between the Japanese economy of the late eighties and the US today that pretty well spoil the comparison. Straightening these out will show that the crisis we face today is very different from the crisis Japan faced in the 90's.
First, the yen does not serve as the global reserve currency as does the US dollar, and Japan intervenes heavily to operate as a mercantilist exporter similar to
the Chinese strategy. Japan runs a tremendous trade surplus, unlike the US. As a result, the economy of Japan developed along very different lines than the US economy has. Japan has little domestic dependence on foreign manufactured goods and a vastly larger manufacturing base. Exchange rate fluctuations would have little effect on consumer prices in such an economy, but a large effect on employment levels and GDP. The opposite is true in the US.
A second side effect of this policy is that most of Japan's government debt is held domestically. Though Japan has a very large debt to service, it faces virtually no risk of a mass sell-off as a result of exchange rate fluctuations as the US does. There is much less risk of a mass sell-off of yen or the Japanese government finding itself unable to borrow, again despite very high debt levels.
Lastly, Japan has an extremely high savings rate in comparison to the US. This means that monetary inflation by the Bank of Japan actually has a savings base representing saved capital to redeploy, instead of being stretched thin as is the case in the United States. Monetary inflation will result in malinvestment and eventually consumer price inflation in both cases, but the responses will be very different. I would expect the US to see price inflation much more quickly than the Japanese economy, which would tend to see many more "bridges to nowhere" built before price inflation kicked in. In other words, rank economic stupidity would tend to show up more in investment patterns in Japan and more in consumption patterns in the US, since the savings rate differential would result in an inflation induced subsidy differential that played itself out over time.
So, overall I think this comparison is quite bad, especially as the dollar is at the center of this crisis. Both countries have fiat currencies that will eventually go the way of all fiat currencies, yes, but other than that our currency situations could not be more different. Very different forces are at work on them.
And while we're on the subject of Japan, I'd like to explode one little myth about Japan that has been tossing about for some time.
Japan has not experienced significant price deflation over the past 20 years. CPI and PPI have bumped around inconsequentially between positive and negative territory. This is a pretty good performance if you ask me, actually. I wish the US had this to look forward to over the next two decades.
Price deflation is not that big of a deal. I know that if I buy a computer today, I can get the same computer much cheaper in a year or two. I still buy computers. Price deflation ought to be a normal part of any economy as money supply remains unchanged but the economy becomes more productive and supplies overall increase. We can see it in the computer industry only because it is developing rapidly in comparison to FED printing. It really should be going on across all industries.
But back to the controversy at hand...
The Great Depression
Actually, the Great Depression comparison fails for many of the same reasons. The America of the twenties was running a trade surplus and behaving much as the mercantilist/creditor nations of Asia are behaving today. Today, we are debtors with a trade deficit. The economy was likewise much more manufacturing based, as one might expect.
However, there are other important differences that have no parallels with Asia. The US was on a "gold standard" at the time, which meant that money could theoretically be exchanged for gold at a fixed rate, provided not too many people did it at once. Let's not kid ourselves here -- the banking system was never all that honest. Fractional reserve banking and the FED were still inflating, but at least there was something to hold over their heads. By the end of WWII, this check had largely been removed, and is completely absent today. Now the accounting is allowed to get much more out of hand before objections get raised.
But probably the biggest difference is the development of a deposit insurance system. Nowadays there is little to fear from bank runs or monetary destruction resulting from bank failure. When banks fail, there is virtually no impact on the money supply. Provided that Congress continues to fund the FDIC, which is pretty much guaranteed, this will continue to be the case no matter how bad things get. But you can expect to see huge fiscal deficits ahead as a result, since the Treasury will be paying for claims over and above the FDIC's ability to pay, which is going to be pretty much all of it.
America also had far less debt back then and no Social Security or Medicare to pay for. There was far less pressure on the government to prod the FED into inflating just to finance the government deficit.
But then again, there was WWII... At any rate, overall, the major forces acting on the economy were quite different in 1929 than in 2009, especially with respect to currency.
Better Parallels
There really are no good historical parallel to America's present predicament. There has never been a global fiat currency system, much less one that operates off a single reserve fiat currency. Most of the banking and financial "innovations" like deposit insurance schemes are fairly new developments.
But there are a few parallels that I think are slightly more fitting. Britain of the twenties effectively made sterling something like the reserve currency of several European nations. Their central banks refused to exchange currency for gold, but would exchange it for pounds sterling, which were then exchangeable for specie (precious metal), again, theoretically, at the Bank of England. This is not exactly the same as today's floating exchange rates since the rates at that time were fixed, but it is reminiscent of the Bretton Woods "gold exchange" arrangement that was the predecessor of today's system.
As the Brits exploited the system by inflating their currency, they set up many of the events that contributed to the Great Depression. They even managed to drag the US into their scheme, as chronicled by Murray Rothbard in
America's Great Depression. This is one of the less discussed contributors to that event, but is possibly one of the most important. Notice that in this scenario, the US is playing more or less the role of today's China, with Britain taking the role of today's US. The parallel has led
some commentators to describe this crisis as China's Great Depression. The fits are inexact, especially with respect to deposit insurance and fixed exchange rates amongst currencies and gold, but better than direct US-US comparison.
Two other parallels are better fitting, in my opinion, even if they are still not very good. Those would be the examples of Argentina and Russia in the nineties. Both nations had enormous foreign debts, implying large trade deficits and weak currencies, and an expansive and expensive welfare state. Both found their central banks forced to debase the currency to cope with the debt burden, and both eventually defaulted and saw systemic political and economic chaos as a result. On the other hand, because their currencies were not serving as reserve currencies for other nations, their individual collapses were mostly contained within their own respective borders and economies. Neither had the extended and complex division of labor that the US has, either, so in many respects, the economic adjustments they had to make were less severe that what the US would be facing.
The True US Debt Burden
A lot of commentators will argue that countries like Japan have a larger debt burden than the US, so they are actually in worse shape. At $12 trillion, the US debt burden has yet to reach 100% of GDP, while Japan is already approaching 200% and rising quickly. Therefore Japan's currency should be under greater threat than the US currency. This is only true in the narrowest sense.
As I talked about last time, a great deal of America's debt burden and future liabilities are off-book, and as Leo pointed out, Medicare and Social Security are both already in the red if you check the numbers closely enough. This means that these hidden liabilities are incrementally being rolled into the official debt numbers, which is a big reason that the deficits have been rising so dramatically.
Using more realistic accounting, the Social Security - Medicare debt burden is in the range of $80 trillion. To this we can add the on budget deficit of $12 trillion, plus the FDIC claims likely to result from bank failures to arrive in the ballpark of $100 trillion dollars. Now, to be sure, not all of this is going to wind up on the official, on-budget deficit all at once. The transfer will be incremental, if at all. But it should be clear: there is no way that the US can possibly pay the interest on this level of debt. At only 3%, interest payments are $3 trillion, more than 20% of GDP. Such payments would absorb pretty much the entire Federal budget.
As it stands, only the interest on the on-budget $12 trillion is actually being paid, with the SS-Medicare interest simply accruing as more meaningless book-keeping IOU entries. Social Security and Medicare effectively operate on a pay-as-you-go basis with some clerk keeping track of the imaginary accumulating deficit that will never be paid.
The government cannot endure 10% unemployment for long. It is driving down tax revenues and increasing welfare claims. We won't persist in this condition as the "Japan Argument" claims. The US is already bankrupt. It is simply a matter of time before the bluff is called. The faster Social Security and Medicare deficits are transferred to on-budget deficits, and the faster the on-budget deficit increases, the sooner the day of reckoning comes.
Then, the history writers will say that an old era ended and a new began. But we will know
the transition actually occurred long ago.
In the wake of the collapse of Fannie Mae and Freddie Mac, the FED appears to have decided to single-handedly take over the responsibility of financing the nation's mortgage markets. Its balance sheet now consists of almost half mortgage-backed securities, with this asset class rising the fastest. I guess the FED has decided that openly flooding the housing market with money is better policy than all that beating around the bush. If it ever stops, look out below.
So, all around it looks like we are in for an inflationary future. However, on the other hand...
Beware the commodities markets!
Oil inventories are up. Copper inventories are up as well.
FEDsters imagine themselves scrambling around trying to keep the interest rate "just right," using their monetary voodoo to fight that terrible, most destructive force of capitalism, the evil business cycle. In this phase diagram representing the imaginary physics of FEDworld, the interest rate increases along the vertical axis and the business cycle advances along the horizontal. By plunking one's finger down at the point that describes some hypothetical condition, one can determine the corresponding "state" of the economy -- recessionary, inflationary, or "just right" non-inflationary growth. The solid lines represent phase transitions, so that if the FED decides, for example, to dial down the interest rate from point A, the economy will undergo successive transitions from recession, to non-inflationary growth, to inflation. Assuming, of course that we could hold time/the business cycle still. Likewise, if we are at point B and the FED simply allows time to pass without adjusting interest rates, marching along to the right one finds that the economy will slip into recession as the business cycle undulates past and a point of the cycle is reached that requires interest rates to be lowered. I have also included a dashed line representing the free-market rate of interest -- the theoretical rate of interest that would naturally prevail under a regime of a fixed money supply.
The FEDsters seem to take this model for granted. It doesn't seem to occur to them that, first of all, the business cycle is not a natural phenomenon of capitalist economies but is actually caused by their own activities and the activities of their crooked cronies the banksters, and second that the upper and lower bounds that constitute their "tightrope" might not actually run parallel at all, but wind up crossing one another as the insidious effects of interest rate manipulation distort the economy. Their supposed "just right" zone is a figment of their deluded imaginations.
Because the business cycle itself is dependent on how interest rates are manipulated and the money supply tampering implied by these manipulations, a more accurate phase diagram would have to run in multiple dimensions as unique business cycles sprouted perpendicular to each unique point of any particular phase diagram. I don't want to try to do this because my head would probably explode, and I don't think it's worth it for a blog post. But allowing ourselves the approximation of a fixed business cycle, I think the phase diagram should look more like this:
The "just right" zone is merely an illusion. Just right is the market interest rate with a fixed money supply, which results in no inflation and no business cycle. Keeping the interest rate below the market rate, which is where the perpetually inflating FED keeps things, can have several different effects depending on just exactly where one is in the business cycle. Early on, it results in a market boom as capital asset prices surge ahead of consumer prices, which the FED and the general public confuse for "just right." Later on it results in outright price inflation, either as recessionary inflation (stagflation) or a more serious case of inflationary expansion, depending on how far the rate is suppressed and how badly the economy was distorted in the boom phase. Only if the economy goes through a period of recession will it recover. There must be a period of time for prices to re-equilibrate so that rational economic calculation can take place again. Either capital goods prices must be allowed to fall, or consumer prices must catch up to the inflated capital goods prices caused by the artificial boom to bring things back into line.
So, contrary to the FEDster's line of reasoning, by manipulating interest rates and the money supply, the FED isn't so much walking the tightrope as walking the plank of the artificial boom. Eventually it runs out of plank and must decide which school of sharks it would rather hazard to dive into.
So far, Bernanke appears to have put us into the stagflationary phase. He has opted for near zero interest rates. He could put us into the expansionary inflation phase by effectively dropping them past zero and charging banks interest for not lending out their reserves, or he could put us into non-inflationary recession by raising them. But a true recession would be a political disaster, and he seems to be unwilling to cross the zero-interest threshold. Likely we'll just sit here for awhile until the truth sinks in -- we won't be able to get growth without inflation. Meanwhile, unemployment and the deficit will climb and the standard of living decline. The inflationary expansion transition line will eventually undulate back up and the non-inflationary recession transition line back down, but there may be some powerful political pressures to "do something" in the meantime. OK, OK, so there already has been. There will also be the unfolding of national default to answer for.
Who knows where all this ends? Maybe the FEDsters will come to their senses and stop inflating. Then we can get back to meaningful economic transactions that build wealth instead of government enforced economic behavior that destroys it. Doubtful, but it might conceivably happen. Otherwise, we are doomed to a prolonged, steady economic erosion as economic reality takes its toll on the fantasies of the FEDsters.
At least, those are my best guesses, which probably aren't as good as any despite the assurance of the cliche to the contrary.
