Japan a Deflation Death? - Nope Stagflation

Gordon Brown this week announced what can only be described as a car boot sale of UK PLC's bric-a-brac goods, an attempt to sooth markets regarding the budget deficit. Many of the items have been for sale before, but I'm sure the government in their current desperation will be willing to accept lower offers this time around. I agree with privatisation in getting the state out of our lives, but a student loan book and a crossing in Kent are hardly big ticket items, never mind the fact that they are assets that generate money. Thatcher sold the majority of the family silver during the eighties privatisation bonanza however contrary to common belief there's plenty more the state could sell. Institutions such as the NHS, education the road infrastructure and so forth could all be sold, but these are not politically palatable areas that the public can swallow, meaning they are off limits for any politician that doesn't want to ruin their career. The Prime Minister once more began another Keynesian rant stating that the Conservatives proposals would lead to the same problems experienced by Japan for the past two decades. The title 'Prudent Chancellor' seems ever more absurd as time goes on, his emphasis on yet more needless spending in an attempt to bankrupt the nation. It doesn't matter if its Americas Great Depression or the lost decade in Japan, economists, politicians and journalists all seem to draw the wrong conclusions. What Gordon Brown in fact proposes are the very same policies that were pursued during both periods above and resulted in stagnation. Japan didn't get ravaged by the 'dangers of deflation', it was instead a good old classic stagflation.

Many Keynesian economists are still baffled by Japan. Over the years, policy after policy has been proposed by their school of thought, all of which involve some form of government action, but time and time again they all seem to fail. The classic Keynesian rebuttal whenever these policies fail is "Well, the authorities didn't do enough". Just like they apparently didn't do enough during the Great Depression. Yet put forward the question regarding Americas 1920-21 Depression and all Keynesian theory goes out of the window. Here Warren Harding, Americas president at the time, cut government spending, cut taxes and in fact did very little during a time when the economy was contracting at an alarming rate with the measure of unemployment rising faster than during the subsequent Great Depression. Yet the economy with market forces in full control, liquidated unprofitable lines of production and subsequently America during the 1920's experienced one of the greatest economic booms in history. The unemployment rate came dramatically down in no time at all, without government spending to alleviate this process as we are now all told. Herbert Hoover, who was later to become Americas President during the next depression, unsurprisingly didn't agree with Harding's polices, a pre-cursor of what was to come. Don't mention any of this to the Keynesian's though, it will give them a real headache.

What did Japan do when their bubble burst? Cut taxes? Cut Government spending? Liquidate? They of course carried out the exact opposite. Their Government debt used to be as low as the UK's before its recent exponential trajectory however Japans now stands at 200% plus and keeps growing. They propped up their infamous zombie banks, crippling the pricing mechanism that is so vital for an economy to prosper. Increases in taxes will choke the economy as rising social costs increase. In order to assess what really happened we need to deal with the aspect of deflation, or what is currently assumed as the bogeyman to economic growth. Japan never entered a downward death spiral of prices, that consistently fell year on year, in fact the lowest their CPI hit during this time was -1%. During the mid-nineties it spiked back up to 2%. There was only around 6 years of official deflation during the two decades using the Governments metrics. What gave the impression of price deflation was in fact asset price deflation. Both real estate and stock prices completely collapsed and have not returned since, instead stagnating for years. The reason why they never recovered to their previous highs was exactly what the Government did, they took over and tried the command economy approach. Roads to nowhere, propping up banks that were insolvent, not allowing private enterprise to take over the means of production. Rather than money going into the private sector, Japanese savings that were accrued during their economic miracle were funneled into Government bonds, wasteful Government consumption. It was quite simply a classic stagflation, that is still ongoing.

The UK are now pursuing similar policies and will go into a long period of stagnation unless the current direction is reversed. However it is useful to try and make further sense of Japans situation during that time, compared with our own. When the crunch came for Japan they ran budget surpluses, had high domestic saving rates for years and were a creditor nation. The UK on the other hand has the complete opposite and relies heavily on overseas investors to buy our Government bonds. Japan only began to run double digit Government deficits eight years later. They were able to sell their bonds to domestic citizens. They were still obtaining plenty of foreign currency as they exported more than they imported. The UK has already printed in excess of 10% GDP to pay for the debts, is running a huge budget deficit only two years after the current financial crunch and for the past decade its citizens have had low savings rates.

So what does all the above mean? Quite simply the UK is in a much more highly inflationary situation that Japan was. Japan's government couldn't really print money until over 10 years later as a last resort due to there being ample savings to pay for the Government debt. Japans government created their budget deficit, the UK has a structural one in which politicians are notorious for not tackling the shortfall. While Japans significant industries, electronics and car manufacture, continued to grow with global demand, the UK's key revenue streams, finance and North Sea, are in decline.

Another key factor is if the Government Bond market is in a bull or bear market. During Japan's economic disaster the bond market was in a bull market. Interest rates kept falling, people still had faith in many paper financial assets. Since 1981/82 Government Bonds have been in a bull market however these things always move in cycles, typically we should be seeing the end to this trend at some point. 25 years plus is a good run and in the near future this will turn into a long, grinding bear market, we may have already crossed that point. In a bear market, interest rates on bonds rise, which means Governments have to increasingly spend more on interest payments, diverting money away from spending such as health or education. Recently the CEBR said interest rates will stay low for the foreseeable future during the first half of the next decade, however that would mean the bond bull market lasting for over three decades, a highly improbable situation.

History is always an important guide to future trends, however it is crucial to compare given contexts in their current time frame. I have seen articles recently stating that Britain had debts in excess of 200% of GDP after the Napoleonic wars, indeed I have mentioned it myself before, however this didn't count for much when the UK went broke in 1976 with debts as meager as 48% of GDP. In the prior scenario the UK was the global superpower but a much bigger factor was that the UK didn't have a Welfare State. There was little government expenditure, with the majority of taxes just going to pay off the debt as alternative expenses didn't exist. Contrast that with current Government spending in which the interest payments are now comparatively small along with a rainbow of other Governmental expenditure, we see how context is key. Somehow, within the time frame of 150 years, Britain had transformed itself from one of the leaders of laissez faire, into a nation that was almost turning Communist in 1976. An ever expansive state, a declining currency, an economy with little productive purpose, meant investors wouldn't lend the UK any more money, despite the debt being around a quarter the level than that of the early nineteenth century.

Japan recently has around the same debt as the UK did 200 years ago and is still able to pay for it. It's dangerous to compare Britain with Japan, as Britain will not be able to sustain a public debt level that high. Japan built this debt up during a bull market in Government bonds and had savings to pay for it. The UK doesn't have either of those luxuries. It's one of the key concepts that many forecasters and economic commentators overlook, the fact that interest rates can rise over time and enter bear and bull markets. Payments for the interest are already predicted to soar as the debt increases based on the current low rates, but what about if those rates double 10 years from now? The government admits the earliest they can balance the books is around then therefore debt is almost certain to keep going up.

Do not believe predictions regarding long term interest rates and the level of debt a country can absorb, no one can forecast precise figures in these areas. Instead look at the fundamentals. Are the government balancing the books? Has the printing press been shut down? Has liquidation occurred? Until fundamentals return then stagflation looks the most likely outcome here in the UK. Just like Japan, only I fear much worse.

The Curse of being a Creditor Export Nation

"Germany was one of the leading borrowers on the American market during the boom. Germany was undoubtedly short of capital, bereft as she was by the war and then by her ruinous inflation, culminating in late 1923. However, the German bonds floated in the United States did not, as most people thought, rebuild German capital. For these loans were largely extended to German local and state governments, and not to private German business. The loans made capital even scarcer in Germany, for the local governments were now able to compete even more strongly with private business for factors of production."
Murray Rothbard, Americas Great Depression

The recent GDP figures in relation to the German economy were dreadful. The economy was reported to have shrunk 3.8% in the first quarter. Later in the week Japans figures came out, again the numbers were once again nauseating. This time a contraction of 3.5% for the quarter along with a collapse in exports. Meanwhile millions in China are being made redundant. Despite the massaged figures that the Communist party reports, China is heading for a hard landing. Many commentators have begun warning the Asian bloc of nations that their export based economic model is flawed, signaling they need to buy our bonds to avert a further collapse in their own economies. Ambrose Evans Pritchard has stated that Asia will author its own destruction if they stop buying US governments bonds, meanwhile Anatole Kaletsky claims that Germans need to abandon their rigid monetary stance and deploy a looser fiscal policy in order to save itself and the Eurozone. Why is it that prudent nations, who saved, lived within their means, who were running trade surpluses during the boom are having a harder time of late than nations such as the UK or US, who did the exact opposite? I mentioned that this should occur back in February, and it is perfectly logical. It is always the prudent that face a worse punishment than the reckless, this is the way it always works.

Think of a hypothetical situation in which Person A works, saves, lives within his means and always seeks to improve his working skills. Person B on the other hand, works as little as he can, doesn't save, borrows as much money as he can and has no interest in bettering himself. Person A has so much saving that he doesn't know what to do with it all, therefore lends it to Person B to fund his lifestyle. It seems like a good idea, as both benefit, one gets interest on his loans, the other is able to live beyond his means. Person B comes to a point where he has simply borrowed too much, but insists that Person A must continue to lend him money just until he gets back on his feet, otherwise he would default on his loans. Person A initially agrees, but as time goes on Person B has still not changed his ways, still threatening that he needs more money as both would be in real trouble if the current agreement stopped. At some point, Person A decides enough is enough and decides to cut his loses. Person B realises he can no longer pay back the money so defaults.

In the above Person A has to go through a lot more pain, as he has essentially just worked and saved for no reason, as Person B defaulted on his loans. He has lost all his capital and doesn't know what to with his future earnings. Person B however has had a pleasant lifestyle and at this point has gained greatly. He hasn't taken the short term hit. Yet despite this, over the long term Person B needs to develop his skill set to pay for his lifestyle he was previously used to and needs to learn once more how to live within his means. Person A meanwhile has the above already and has a head start on person B. Over the long term he is in far more beneficial position as he re saves his money, continues working and has learnt a lesson not to take excessive risk by lending to individuals such as Person B.

The above is an extreme and simplified situation but illustrates the global issues we are now seeing. Despite all the empty threats Hilary Clinton sends to China to continue buying US government debt, as soon as creditor nations decide to cut their losses the better they will be in the long term. This is the decoupling commentators such as Peter Schiff mention. The initial stages will be very painful for the creditor export based nations, but over time they will write off these losses and move forward consuming more of what they produce, rather than shipping it to others who can't pay.

The globe was at a similar junction during the Great Depression. Back then America was the creditor export nation of the world, making loans to Europe and assisting with the inflationary program Britain was pursuing as she tried (and failed) to keep the pound artificially high. During the 1920's Europe was a economic fiasco. Germany witnessed the collapse of the Mark, Austria nearly had a similar fate, France was weak, Britain was struggling with her empire and Russia had cut itself off as it succumbed to Communism, embarking on the road towards impoverishing her people. When the phrase 'roaring twenties' is used, it never applied to Europe, America was the creditor of the world producing and exporting some of the most innovative products of its day. With this surplus she helped nations in Europe, even into the depression;

"The New York Federal Reserve loaned, in 1931, $125 million to the Bank of England, $25 million to the German Reichsbank, and smaller amounts to Hungary and Austria. As a result, much frozen assets were shifted, to become burdens to the United States. The Federal Reserve also renewed foreign loans when borrowers failed to pay at maturity."
Murray Rothbard, Americas Great Depression

Economists always like to mention the fact that European nations never had as bad depression as America, such as the BBC's commentator Stephanie Flanders, however comments like this miss the whole economic perspective and analysis. Europe never had a boom, therefore it didn't have as hard a time as the US, instead during the 1920's many of the continents nations experienced high inflation to erode the value of debts obtained during the First World War. Over the long term America, as history showed, bounced back and became the economic superpower. During the 1950's and 1960's American products were practically unbeatable and she also assisted with Europe's Reconstruction after WW2 with the Marshall Plan.

The recent idea that a nation who consumes too much is doing nations that live within their means a favour is absurd. Its much easier for one to consume than to produce. Generally once a nation becomes a debtor for consumption purposes it becomes very hard to break the cycle, as increasing amounts of money is used for further short term consumption or paying interest on the existing debt. Many Eastern European states borrowed heavily from the West for such means while they were still within the unproductive Iron curtain. Nations such as Poland, who in 1970 were 1.1B in debt, increased these overseas debts to 25B ten years later. This money was not used wisely as it was just used to consume goods rather than to increase productive capacity. Many such nations experienced mass inflation with the economies being effectively Dollarised (foreign visitors were quite frequently asked by the locals to pay for goods or services in Dollars rather than the local currencies).

Many commentators justify Americas recent borrowing stating that America borrowed hugely from European countries such as Britain and Germany in Europe during the 19th Century, but again they miss the point. Back then this money was used for production, not consumption. Countries like China recently have borrowed huge amounts of money from the West, however they have used this money for production purposes or investing in human capital. There is nothing wrong with borrowing money - it's what you do with it that matters.

America up until the eighties was a creditor nation, it was during Reaganomics that it chose to become the worlds largest debtor in history. Once travelling along this path it becomes very hard to stop or reverse. Tough choices have to made by politicians and the countries citizens, all of which are avoided until it is too late.

Don't get me wrong, there are issues with many of the worlds creditor nations. The Saudis are ruled under a despotic regime, Russia still suffers from decades of Communist decay, China has too much bureaucracy, Germany has a rigid labor force and Japan has huge amounts of Government debt, increasing as the crisis deepens. In short I think the whole world has issues.

Keynesian economics always tells people what they want to hear, mainly it is an economic framework that provides individuals with the notion of a free lunch. As Milton Friedman said "There is no free lunch", every action has a cost. Consumption, Debtor nations will have to pay more for their situation than the export and creditor nations in the long run. There is no curse for being an export creditor nation. The curse is a Keynesian myth, the economic school that once again gets the wrong end of the stick. The curse lies with debtor consumption nations. It always has and always will.

The Descent of Niall Ferguson?

We came close to financial collapse, Wall Streets big Investment banks went bankrupt or were merged into other banks, the IMF bailed out various countries from monetary implosion, Sterling plunged, Governments turned to Socialist solutions, the myth of houses being a 'safe investment' was derailed. In all the turmoil with every asset in sight heading south, historian Niall Ferguson was on our screens again, this time with a series titled "The Ascent of Money" to promote his new book. A six part series that looked at the historical impact of finance within human society and how it has evolved, into the modern system we now use in our economies. I personally enjoy reading Niall Ferguson's books and there are some interesting titles to his name, my favourite being Empire: How Britain Made the Modern World. After the last episode there was an open web chat in which he answered peoples questions, which can be found here. Like the television series, Prof Ferguson seemed to have flawed analysis of economic matters, such as deflation and inflation which I wish to explain briefly here. Inflation and deflation is strictly a monetary phenomenon, it is caused by an increase in paper money compared with the goods and services in an economy. This shows up as rising prices, however the goods do not rise in price from market forces, but from monetary expansion. For the sake of this article, I may refer to deflation as falling prices, but technically it is a falling money supply. However I will use this definition to elaborate on Prof Ferguson points in question. I have selected some of the quotes he made in the online discussion that I found interesting.


"Well, right now Ben Bernanke is more worried about deflation than about inflation. But if he's successful we can soon revert to worrying about inflation. As I said in an earlier post, central banks today do not want 0% inflation (i.e. price stability). It limits the room for monetary policy too much. Are we going to see a big surge in inflation after this crisis is over? I frankly doubt it. The Fed can mop up a lot of this excess liquidity quite easily, as the Bank of Japan did after the end of quantitative easing."

The above analysis is flawed, in many aspects. First of all, that we are suddenly worried about deflation. This is a myth, as the past couple of decades have been deflationary. As I've said before market forces are always deflationary, people reinvest capital to increase productive capacity, thus reducing the cost of goods and services. Prof. Ferguson confuses general deflation, with the aspect of deflation that Ben Bernanke is worried about, that is asset price deflation - houses and stocks. As the US and UK have consumption debt based economies, where the 'wealth' is based on the price of the above assets, when these are falling in value then the economy contracts. This is what the Western Central Banks are worried about, as our whole economy revolves around these assets. They will inflate these assets at all costs, hence why they want to print money. History has always shown governments will do this as people want the government to take action. Prof. Ferguson does not mention any of this which is a big omission. He also doesn't mention it in the television series.

Apart from the first episode there is no great mention about inflation. Inflation is a purely monetary phenomenon, which amazingly he doesn't seem to explain in great depth. In order to obtain the 'price stability' he references above, central banks must constantly inflate the currency as the prices of goods and services continue to fall. Achieving price stability is a path to periodic financial crisis. Price stability helped cause the Great Depression, as the FED had to inflate during the 1920's in order to ensure inflation was ticking along, fighting against the deflationary forces of industialisation. Then when the bust came in, they tried to inflate to keep inflation up (i.e. keep wages, agriculture and stock market prices high), however they were beaten in the end by the gold convertibility so deflation won in the end. Rather than the economy resuming normal operation it stagnated for years due to the huge inflation in the proceeding years, accompanied by the draconian measures that were introduced as the government constantly interfered during the bust. It wasn't deflation that made the great depression, it was the inflation in the stock market. Then there was the stagflationary seventies. All currencies were off gold, therefore governments this time could inflate so inflation reached as high as 25% in Britain. Again the result was the same - economic hardship for years. It was inflation again in the 50's and 60's into asset prices that caused this as central banks looked for 'price stability'. Yet again, we are following the same foolhardy decisions, as price stability causes financial instability.

When Dr Ferguson mentions this price stability he says it limits the room for monetary policy. Does he really understand what he is saying here? The only thing it limits is the economies ability to re-deploy its resources efficiently and effectively. It has helped cause the stock market bubbles and the housing bubbles with the recent one, being one of the prime reasons we find ourselves in this mess as Greenspan and Co decided we had to pump cheap money in the system to ensure 'Price Stability' to combat these deflationary forces. They expanded the money supply so much that the West quite simply misallocated its resources in the wrong areas, hence the major correction we are now going into. Capital should always be scarce despite what people say, as it tries to direct a scarce amount of resources in the real economy into the required productive channels.

Then we come onto his other comment regarding if we going to see a big surge in inflation, in which he doubts we will. His reasoning is that we will be able to mop up any excesses like Japan. Like Japan did? As I have mentioned before, and unfortunately our governments have begun implementing this policy, Japan cut interest rates to 0% and tried to inflate to cure their downturn in the 90's but all it did was kill the economy. They also tried the new buzz word in the media "Quantitative Easing" which is effectively printing money, as I have earlier warned about. The reason Japan didn't experience inflation domestically, was that they exported this excess money to the world. Japan exported inflation to the world. You have probably heard of the Yen Carry trade well this is what it was in effect, people buying up huge amounts of Yen at cheap rates and putting the money to use in other countries where the returns were higher. It was also the reason for the Yens surge this year, and the deleveraging we saw in the autumn and winter of 2008 as these returns evaporated and the Yen increased in value against all currencies - people had to sell to cover these loses. This is also one of the causes of our asset booms in the stock market and housing. If it wasn't for this and the fact Japan is a huge creditor nation who have a trade surplus, they would have experienced huge inflation. So then we ask the question, how will the West mop up this excess money if the majority of the worlds economies are doing it? Quite simply, they can't, once this money is in the system along with less goods and services (which is what is happening at the moment as businesses won't invest) inflation is inevitable. The only way to stop it is by raising interest rates to double digits, a policy politicians don't particularly like, as Margaret Thatcher found when she became a demonised figure. Our economy is based around debt, so they are not going to be doing this for some time.


"Don't know the book. But people are always writing things like that. My favourite is William Rees Mogg's Great Depression of the 1990s, which never materialized (rather the reverse). Usually the predicted event doesn't happen. Sometimes it does -- though by 2010 I suspect we'll be out of this hole and Harrison's book will be out of print."

The comments above are in regards to Fred Harrison's book, Boom Bust: House Prices, Banking and the Depression of 2010, this is also a book I have read. Yet if Prof. Ferguson had done sufficient research and indeed read the book before passing judgement, he would have discovered that there is a very set pattern for the gap between each housing boom, specifically 18 years which Fred Harrison shows in his book. The book was also written in 2005, just as the housing market was slowing down and many thought it would collapse, however Fred stated that it would carry on for another two years, the period he terms as the "winners curse". He also said it would carry on with double digit rises, when everyone said it would slow to more moderate growth, as he claimed hysteria would grip the market once more. He also wrote a book back in the early eighties, The Power in the Land, in which he predicted the recession of the early nineties, so this is not a one off.

The assumption that we will be over the worst by 2010 is wrong and sounds like he has been listening to the Labour Government. This stagnation will go on for years in the West. 2009 will be even worse, with more bank failures, huge unemployment, and rising debt. Government finances will be in a hideous state and 2010 will be a grim year too, with in all probability the beginning of what will be years of inflation, as 2009 winds down.

"No, we are in a very different situation from the world in 1929, although the potential was certainly there for a Great Depression 2.0. The key difference is that the Federal Reserve System and the U.S. Treasury are doing everything in their power to combat the collapse of the banking system. And so far they've done a pretty good job. I find it hard to believe that this time next year will be so worried about deflation and depression. The conversation may even have switched to inflation and the need to reverse some of the stimulus that was injected."

The final sentence of the above comment concurs with the first statement in this article, however it is his comments regarding the authorities' interventions that I wish to tackle, as he quite clearly has a incorrect interpretation of history. As I have shown in a previous post the Great Depression was caused by government intervention, the Federal Reserve slashed interest rates from 6% to 1.2% and took all sorts of financial instruments from the banks to prop them up. Prof Ferguson seems to place a belief that they have done a good job, however President Hoover was saying exactly the same at the end of 1930. It wasn't until the second half of 1931 when things really were desperate, and the previous measures had quite clearly had no effect. Governments make the situation worse, which I will dedicate a post at a later date to fully explain why free markets should never be interfered with, even during a bust. He's right in once aspect that later in 2009 we shouldn't be worried about deflation, the monetary expansion along with the depletion of goods should ensure a resurgence in inflation again. We are facing a depression, even if the authorities never admit it, but it will be an inflationary depression.


These were just three of the comments he made in the web chat, I didn't feel the need to choose anymore comments as the post would have been too long. There were some good points regarding the Socialist Chilean President Salvador Allende from various posters and from Prof. Ferguson himself. His successor, General Pinochet was a tyrant and an oppressor of personal liberty, but Allende would not have been the Socialist Utopian alternative, as so many among the left like to believe. Before the coup, Chile was already showing signs of Totalitarianism, along with the classic hallmark of Socialist overspend resulting in the escalation in inflation. There was quite an extensive debate on this subject matter, with some emotions running high.

One of the terms coined in the series is that of "Chimerica", or the union of China and America in recent times. Ferguson paints a rosy picture of this relationship, although he does mention the possibility of a Third World War between the two without the mention of possible alliances. In one of his books "Colossus: The Rise and Fall of the American Empire", he evidently can see that America is on its way out as the worlds superpower, displaying signs of overstretch and faltering economic growth, similar to Britain's decline, decline that I suspect we will see over the coming decades (as empires always decline in over a long period of time). In the book he doesn't use the term Chimerica but acknowledges the China effect and the deficits that America is running with the rest of the world. This is one point he doesn't make an issue of in the series, which in my view is a major point. Britain, when it began its decline, was a large creditor nation with assets all over the world. America, on the other hand, is a huge debtor nation the largest in history with very little in terms of overseas assets. America, is in a far worse state than Britain was during its decline. Yet Ferguson seems to believe that America will be the main economic powerhouse for years to come. I disagree, and think he has overlooked this fact, or forgot to mention this historic parallel. The globalisation of today is far different to the one before the first world war. He mentions British trade with China, however the Chinese were very restrictive back then, only allowing European merchants to trade at key ports. They had no access to mainland China, and shifted their goods through the local merchants. In this recent revisit of Globalisation, the situation is very different. China now produces and exports huge amounts of goods to the West, and have modern economic capabilities. They are becoming self sufficient, while the West now relies on their productive facilities to make goods. This is why this time it is more experimental, as the West slowly loses its status as the economic center of the world.

In the final series Prof. Ferguson detailed the various financial events of the past two decades, from the Savings and Loans Crisis, the Asian financial crisis, the Russian Government Default, LTCM collapse, the dot com bubble, Enron then finally the housing bubble. Yet he didn't link into what caused these events, and how they kept reoccurring. Again the Federal Reserve has fostered these, and persistently distorted the market causing the major downturn we are now seeing today. All the above is created by Greenspan and Co who kept bailing the markets out. People were amazed that Lehman Brothers went bust last year, but half of those US investment banks should have gone bust 10 years ago, along with LTCM at the time. He instead pins the mistakes on human behaviour and markets. This is not true, as the market would have corrected these excesses long ago, instead the Central Banks kept bailing out everyone. In other words they took the risk out of the free market. The free market therefore did not price risk, which is a reason why the banks have so many issues we see today. This omission was fatal, as it explains the bust we are going into is not a product of the true free market, or the product of Capitalism (as many anti-capitalists have begun prophesying its downfall) but the product of Central Bank intervention. The market would have corrected all the above long before, thus we would have never had house values escalate as high as they did and an economy orientated so heavily towards these asset prices. These banks would have gone bust long before and along with it more sensible lending standards, with a more balanced economy.

After viewing the series I don't think I will be buying the book, and will probably wait until it becomes available at my local library. I was also disappointed that the series did not go into the details of fractional reserve banking, Central Banks and the artificial market forces that China have been exerting in recent years in order to grow their economy quicker. There was also a lack of history towards recent financial events, which would explain more clearly the predicament we find ourselves in. However, Prof. Ferguson is an academic, not an economist. His book Cash Nexus, another book that I have read, he declares gold as an old relic with comments such as "Gold has a future, of course, but mainly as jewelry". This was in 1999, around the bottom in Golds price, since which Gold has increased around 400%-500% in Sterling a decade since these comments. Other recent comments such as "Money is trust, not metal", is true with our modern fiat currency, however only metal ever keeps its value over history. Another historical point Prof. Ferguson misses.

Alan Greenspan, who helped cause the current issues we see, understood the damage central banks and a fiat monetary system can cause. Back in 2002 Ron Paul asked him about Gold and Economic Freedom, an essay he wrote (in which I have taken an extract from), and if he still believed it to be true and valid for today. He responded with "I wouldn't change a single word". It's a shame many mainstream commentators such as Prof. Ferguson can't see the flaws in our current system. Greenspan could.

"But prior to World War I, the banking system in the United States (and in most of the world) was based on gold and even though governments intervened occasionally, banking was more free than controlled. Periodically, as a result of overly rapid credit expansion, banks became loaned up to the limit of their gold reserves, interest rates rose sharply, new credit was cut off, and the economy went into a sharp, but short-lived recession. (Compared with the depressions of 1920 and 1932, the pre-World War I business declines were mild indeed.) It was limited gold reserves that stopped the unbalanced expansions of business activity, before they could develop into the post-World War I type of disaster. The readjustment periods were short and the economies quickly reestablished a sound basis to resume expansion ... In the absence of the gold standard, there is no way to protect savings from confiscation through inflation. There is no safe store of value."
Alan Greenspan, Gold and Economic Freedom, 1967
Note: The Federal Reserve was established in 1913

The Run on the Global Financial System

The systematic liquidation of the financial system has truly gripped the worlds attention this week, as fear has spread to all facets of society. Global Stock markets have been crashing. As prices fall, margin calls are being made ensuring further deleveraging of positions. Comparisons with the Great Depression have become widespread in the mainstream media. World leaders and Central Banks have been meeting to try solve the issues, with co-ordinated interest rate cuts and monetary packages. Iceland, a whole country, is on the verge of collapse. Citizens everywhere have been withdrawing savings from banks, feeling safer holding cash themselves. Physical precious metal dealers are running out of gold and silver. The American mint has stopped issuing certain gold coins. All assets are in free fall with no place to go, apart from cash. Libor is rising, the Fed's balance sheet has exploded, talk of the CDS meltdown has begun as positions at Lehman, the recently collapsed investment bank, are unwound. The US debt clock in New York has run out of digits. The UK has part nationalised it's remaining banking system, after the full nationalisations of Bradford and Bingley and Northern Rock. If the general public didn't realise the severity of the situation before, they do now, after a week of paralysis and sheer terror caused by decades of high finance prominence, as savings and production were side lined for the new age. The public will pay dearly for the misallocation of capital, the loss of private savings and the end of cheap energy in the years to come. To illustrate what an unusual week it was, we saw Gordon Brown making banking jokes. It was a week of many surprises.

The years to come will be more of the same with many mini crisis to come. And in times of crisis, history has always shown there is great change. Politicians and governments always intervene in a panic stricken manner when all around them seems to be crashing and failing. Emergency laws are enacted for the 'good' of the nation. Normality of the past, has been replaced with the normality of the foreseeable future. This brings me to the point of what could possibly happen over the next decade. There are many interesting and viable possibilities that could occur and I will explain my thoughts on what actions could be taken, in order to try and stem the future crisis that will take place.

• Confiscation of gold is more than plausible or the suspension of moving from paper assets into gold and silver. Precious metals are always seen as a safe haven when finance is in trouble. As the mistrust of paper based money becomes more prevalent after years of financial incompetence, people will start looking for tangible assets, ones outside the system. It would be an irrational decision and make no sense, but our leaders always seem to endorse those types of ideas.
  
  
• I still believe in inflation in medium to long term. Prices may be falling currently but this is deleveraging not deflation. The governments and authorities are embarking on the great reflation, slashing interest rates, pumping future earnings into the system. Therefore I can see certain key commodities becoming very expensive and price controls at some point seem likely. Of course an idiotic policy, but they did it in the seventies.
  
  
• Rationing is also a policy I can see been implemented at some point in the future. Food and energy rationing may become standard.
  
  
• Further nationalisation of the system. The banks are gradually relying heavily on governments, but it won't stop in the finance sector. You will probably see airlines, car makers, other key industries handing out the begging bowl for government intervention. If we begin drinking vodka and producing fine cigars, then we know we really are in trouble.
  
  
• Higher taxes sometime in the future are inevitable in my opinion. We are accumulating huge amounts of debt, more future promises to pay based on future earnings, with no current capital now. Western governments can't manage the books, and were running deficits well before the slowdown in the global economy. All of these future earnings may be severely impeded by our ageing populations and the end of cheap energy. I think Colin Campbell, a prominent proponent on the peaking of Oil, summarises it well in a speech he gave to Parliament in 2004 about the coming oil depletion, where only 3 MEPs bothered turning up.
  
  "The perception of looming decline may be worse than the decline itself. There will be panic. The market over-reacts to even small imbalances. Prices are set to soar in the absense of spare capacity until demand is cut by recessions. We will enter a volatile epoch of price shocks and recessions in increasingly vicious circles. A stock market crash is inevitable."
  
  And this from a geologist, someone not specialised in the details of economics and finance.
  
  
• Further government borrowing will have further consequences on how much money our governments can keep borrowing, and if they can find a buyer. As Robert Preston, a mainstream journalist states:
  
  "Possibly the biggest risk for the US is that in bailing out the finances of the private sector, Paulson would dent international investors' confidence in the American government's balance sheet - which could ultimately undermine the dollar, push up inflation even more and raise the cost of servicing debt for the US authorities."
  
  What happens if the Saudis, Japanese and Chinese don't want to keep lending money to the West? We have little capital in our own societies. The prices of government bonds will go up, as investors suddenly realise certain institutions have no intent on making good on their promises as the currency devalues further.
  
  
• Interest rate cuts have been used progressively over the past year. The trend will continue. They will fight the inflationary boom, that has just occurred, with more inflationist policies during the bust. Don't expect to be living on easy street though. Debt is far too high and the last thing banks are thinking about are more risky loans, just as defaults are rising and capital is being destroyed at a rapid rate.
  
  
• I heard recently that bonuses in the city this year are due to decline 60-70% this year. As I have said in a previous post, finance will be in big decline for years to come. The age of excessive rewards are over, and in my opinion finance will become a middle earning job, with places like New York and London, that were heavily reliant on high finance to be in a state of terminal decline. For how long who knows. We may have seen a top, for the rest of our life times.
  
  
• It may be all hands to the pump, co-ordinated action, on the current events, but this may turn as time goes on. Protectionist policies and the hoarding of certain assets will become more and more common between countries.
  
  
• Regarding the above, if the flight of investors from certain countries does occur then governments may freeze assets to try and keep them within their borders, enacting emergency laws.
  
  
• Wars regarding resources are bound to become more prominent. We have already had the invasion of Iraq and Afghanistan, which was the establishment of a middle east police station for the West. With more shortages to come, these areas will be of critical importance to many economies, with countries organising themselves into coalitions. China has already been in agreements with Venezuela regarding Oil supplies to name one of many relationships that are being formed. Water will become more important, with the potential for conflict between Israel and Palestine, Pakistan and India to name a couple. The Twentieth Century was the most bloody Century in human history, with the second half involving more deaths. I expect the first half of the twenty first century to continue this trend and be even more bloody, although I do hope I'm wrong on this point.

I suspect there will be a rally in the markets next week. The governments should be able to calm investors fears in the short term. More runs and panics will happen over the following years. With these events will come great changes. We are all in uncharted waters. Governments have the buckets at hand, but will it be enough to save the sinking ship? Or is the ship destined to sink as the damage done so far, is irreversible?

The Next Great Depression?

A great deal can be learnt through history. In a practical sense its completely useless, as it merely just documents past events, but past events can help explain current and possible future events. If you can never get to grips with a subject matter it is best to look at history to try and to identify possible similarities. I have taken some quotes from a historical book and I think a lot of the quotes below could be said of the current situation we find ourselves in.

"If the Federal Reserve had an inflationist attitude during the boom, it was just as ready to try to cure the depression by inflating further. It stepped in immediately to expand credit and bolster shaky financial positions. In an act unprecedented in its history, the Federal Reserve moved in during the week of the crash—the final week of October—and in that brief period added almost $300 million to the reserves of the nation’s banks. During that week, the Federal Reserve doubled its holdings of government securities, adding over $150 million to reserves, and it discounted about $200 million more for member banks. Instead of going through a healthy and rapid liquidation of unsound positions, the economy was fated to be continually bolstered by governmental measures that could only prolong its diseased state."

"The Federal Reserve also promptly and sharply lowered its rediscount rate, from 6 percent at the beginning of the crash to 4.5 percent by mid-November. Acceptance rates were also reduced considerably. This enormous expansion was generated to prevent liquidation on the stock market and to permit the New York City banks to take over the brokers’ loans that the “other,” non-bank, lenders were liquidating."

"Dr. Anderson records that, at the end of December, 1929, the leading Federal Reserve officials wanted to pursue a laissez-faire policy: “the disposition was to let the money market ‘sweat it out’ and reach monetary ease by the wholesome process of liquidation.” The Federal Reserve was prepared to let the money market find its own level, without providing artificial stimuli that could only prolong the crisis. But early in 1930, the government instituted a massive easy money program. Rediscount rates of the New York Fed fell from 4.5 percent in February to 2 percent by the end of the year."

"During 1930, the Federal Reserve had steadily lowered its rediscount rates: from 4.2 percent at the beginning of the year, to 2 percent at the end, and finally down to 1.2 percent in mid-1931."

"President Hoover was proud of his experiment in cheap money, and in his speech to the business conference on December 5, he hailed the nation’s good fortune in possessing the splendid Federal Reserve System, which had succeeded in saving shaky banks, had restored confidence, and had made capital more abundant by reducing interest rates. Hoover had done his part to spur the expansion by personally urging the banks to rediscount more extensively at the Federal Reserve Banks. Secretary Mellon issued one of his by now traditionally optimistic pronouncements that there was “plenty of credit available.” And William Green issued a series of optimistic statements, commending the Federal Reserve’s success in ending the depression. On November 22, Green said: All the factors which make for a quick and speedy industrial and economic recovery are present and evident. The Federal Reserve System is operating, serving as a barrier against financial demoralization. Within a few months industrial conditions will become normal, confidence and stabilization in industry and finance will be
restored."

"By early 1930, people were generally convinced that there was little to worry about. Hoover’s decisive actions on so many fronts—wages, construction, public works, farm supports, etc., indicated to the public that this time swift national planning would turn the tide quickly. Farm prices then seemed to be recovering, and unemployment had not yet reached catastrophic proportions, averaging less than 9 percent of the labor force in 1930."

"During the second half of 1930, production, prices, foreign trade, and employment continued to decline. On July 29, Hoover called for an investigation of bankruptcy laws in order to weaken them and prevent many bankruptcies—thus turning to the ancient device of attempting to revive confidence by injuring creditors and propping up unsound positions."

"As a consequence, while the immigration law had already reduced net immigration into the United States to about 200,000 per year, Hoover’s decree reduced net immigration to 35,000 in 1931, and in 1932 there was a net emigration of 77,000. In addition, Hoover’s Emergency Committee on Employment organized concerted propaganda to urge young people to return to school in the fall, and thus leave the labor market."

"He hailed the Federal Reserve System as the great instrument of promoting stability, and called for an “ample supply of credit at low rates of interest,” as well as public works, as the best methods of ending the depression."

"As 1931 drew to a close and another Congressional session drew near, the country and indeed the world were in the midst of an authentic crisis atmosphere—a crisis of policy and of ideology. The depression, so long in effect, was now rapidly growing worse, in America and throughout the world. The stage was set for the “Hoover New Deal” of 1932."

"During 1929, the Federal government had a huge surplus of $1.2 billion"

"From a modest surplus in 1930, the Federal government thus ran up a huge $2.2 billion deficit in 1931."

"One thing Hoover was not reticent about: launching a huge inflationist program. First, the administration cleared the path for the program by passing the Glass–Steagall Act in February, which (a) greatly broadened the assets eligible for rediscounts with the Fed, and (b) permitted the Federal Reserve to use government bonds as collateral for its notes, in addition to commercial paper"

"Thus, the Hoover administration pursued a giant inflationary policy from March through July 1932, raising controlled reserves by $1 billion through Fed purchase of government securities. If all other factors had remained constant, and banks fully loaned up, the money supply would have risen abruptly and wildly by over $10 billion during that period. Instead, and fortunately, the inflationary policy was reversed and turned into a rout. What defeated it? Foreigners who lost confidence in the dollar, partly as a result of the program, and drew out gold; American citizens who lost confidence in the banks and changed their deposits into Federal Reserve notes; and finally, bankers who refused to endanger themselves any further, and either used the increased resources to repay debt to the Federal Reserve or allowed them to pile up in the vaults. And so, fortunately, inflation by the government was turned into deflation by the policies of the public and the banks, and the money supply dropped by $3.5 billion."


Notice some parallels between the present and the period being described above? The things I find most striking are the fact the FED drastically cut rates from 6% to 1.2%, compared with today in which they cut from 5.25% to 2% at present. Also the fact that at the beginning of the bust the government were running huge budget surpluses, and within a couple of years were running huge deficits, compared with now where the US has persistently for years now been running up huge deficits which will get worse.

Of course the period being described was the Great Depression and the Quotes were taken from Murray Rothbards book, Americas Great Depression. Contrary to what people believe the great depression was not suddenly brought about after the infamous stock market crash in October 1929, it was brought about over a 3-4 year period of excessive monetary inflation in the previous years during the 1920's boom and increasing inflationary policies during the bust along with increased government interference, which made the Depression so great. In fact the stock market also rallied during this time and didn't bottom out till around 1933. Hoover was the creator of the New Deal, Roosevelt just merely carried on with it with even more enthusiasm contary to the myth that Hoover had a no hands approach to the economy. In the end this is where we now stand,


"But here, in the crisis of 1933, the banks could no longer continue as they were. Something had to be done. Essentially, there were two possible routes. One was the course taken by Roosevelt; the destruction of the property rights of bank depositors, the confiscation of gold, the taking away of the people’s monetary rights, and the placing of the Federal Government in control of a vast, managed, engine of inflation. The other route would have been to seize the opportunity to awaken the American people to the true nature of their banking system, and thereby return, at one swoop, to a truly hard and sound money."


We all know what happened in subsequent years. Nixon removed the US from the gold standard, and in effect all western currencies from gold as bretton woods was dissmantled. Now the dollar and world currencies are backed with nothing as we enter another dissasturous chapter in history of fiat currency.

If we wish to draw the parallels to today, roughly in 1928 real estate prices began to fall compared with 2006 in the US. 1929 and stock prices began to fall, compared with 2007 when the Dow was at its all time high. So what does that mean in the next few years if we are only at 1930. Well we have a lot further to go and the governments and Central Banks are doing exactly what history has taught us not to do.

However there are differences, which I believe position the US in a worse position. Back then the US had huge budget surpluses in previous years, exported goods throughout the world and had huge oil reserves (cheep energy reserves which can never be overstated). They also theoretically had the dollar backed by Gold which meant even though the FED tried to inflate they were constrained, where as now it is a complete fiat currency meaning there will be no limits to inflate this time. Ben Bernanke the current head of the FED is supposedly a student of the Great Depression but from what I've seen, he's repeating what was done 75 years ago, and he's doing a pretty good job of fooling everyone. Nationalising Fannie and Freddie Mac, that were created at the end of the Great Depression, is an absolute disaster as I have said before, and is exactly what President Hoover and the FED would have done during the last depression.

I will end on the following note from Murray Rothbard. Maybe we are facing another depression and crisis of the same magnitude? Or worse?

"What was the trouble? Economic theory demonstrates that only governmental inflation can generate a boom-and-bust cycle, and that the depression will be prolonged and aggravated by inflationist and other interventionary measures. In contrast to the myth of laissez-faire, we have shown in this book how government intervention generated the unsound boom of the 1920s, and how Hoover’s new departure aggravated the Great Depression by massive measures of interference. The guilt for the Great Depression must, at long last, be lifted from the shoulders of the free-market economy, and placed where it properly belongs: at the doors of politicians, bureaucrats, and the mass of “enlightened” economists. And in any other depression, past or future, the story will be the same."