Sunday, September 28, 2008

Where's a Good Economist When You Need Him?

Since 1929 and up to this moment, well-known economists have yet to come to a truly useful explanation of how and why the Great Depression happened. Modern economic researchers would all agree, I think, that all they have produced so far is a number of inconclusive conjectures.

I personally believe that a few lesser-known economists did actually get it right, with little variance among them. Among these the one whose name is most familiar to me is Edward C. Harwood of the American Institute for Economic Research. (See his book Cause and Control of the Business Cycle and the monologue-booklet Keynes vs. Harwood by Professor Jagdish Mehra, available at AIER.)


The fact that so few have taken Harwood's ideas seriously is unfortunate, because as I look through his research today I find it irreproachable. The closest he came to valid criticism was the comment that his statistical series did not prove cause and effect any more than any other coincidental movements would. The response to this is twofold:

- Okay, but in order to disprove the theory, you have to prove that this specific cause did not or could not perpetrate the effect, or that something else did (and for you methodology students, his theory is falsifiable, unlike the non-existence of green swans); and

- Harwood's pesky little theory has the annoying habit of correctly predicting all of the recessions since 1929 up to Harwood's demise in 1980, and even thereafter up to today's latest fiasco. (It did give a couple of false positives; but that's statistically acceptable, given that government actions or economic events can forestall busts temporarily.)

The economic phenomena present in today's credit crunch are strikingly similar to those of 1929; and Harwood's theory seems to fit once more. His Institute has been warning of a recession for several months now, and it looks like they're going to "get their wish," even though the marketplace has resisted up to now with less efficacious wishful thinking.

If I understand Harwood's theory correctly, the basic tenets are that two misalignments caused 1929 (and in fact equivalent ones have caused every boom/recession cycle since then):

1. After the First World War, the government purposely inflated the money supply so as to finance the war effort. Instead of allowing that supply to deflate back to gold-standard measures, they chose to allow it to continue. Excess purchasing media therefore circulated throughout the next decade, creating the boom cycle that ended with the 1929 bust.

2. Related to the above-mentioned inflationary actions of the government were the slipping banking standards of the times. Banks had begun to expand credit at an unhealthy rate, as follows:

Harwood believed in what he called "sound commercial banking," whereby banks would operate on a 20 percent or higher fractional reserve system under a federally-defined gold standard, and their functions would be divided into two distinct operations: Commercial operations, and savings & loan operations.

Commercial banks should only function as creators of credit to the extent that they had checking accounts, capital, and commercial paper (real bills) representing goods coming to market within three to four months.

Savings & loans, on the other hand, should only give as much credit (i.e. acquire investment-type assets) as they had deposits and capital (savings-type liabilities). These two quantities should remain in constant balance.

But as it happened in the 1920s, banks' accounts became unbalanced. They had begun to create credit on the basis of things other than those stated above, i.e. upon real estate, stocks and bonds, and other unsound collateral, taking on too much risk. (Sound familiar?)

This excess credit manifested itself as excessive money supply, the proverbial "too much money chasing too few goods." Harwood went to the trouble of calculating the extent of this money-supply overextension, calling the results his Harwood Index of Inflating. He used this Index to predict the coming bust, as witnessed in the 1928 and mid-1929 articles he wrote for the New York Times's weekly journal called The Annalist and other papers of the day. The crisis hit in October 1929.

He went on to use that index and his research to predict just about every single recession and inflationary episode in 20th Century monetary history, up until his death in 1980.

What a pity no one has bothered to dig up this valuable research and vet it through application of modern economic expertise--although one wonders just how much expertise there is, given the mess we're in. (As I've noted before, lots of people knew this mess was coming, most notably the BIS, or Bank for International Settlements, a collection of central bankers; but it has taken them eight years to draw up some ideas of how to impose new banking rules to lessen the dangers--six years too many.)

What a loss that we don't still have Harwood around today, bellowing warnings from the rooftop of his Institute and allowing us all to take protective measures to preserve our purchasing power in the scary months ahead.

(For more on Edward C. Harwood, see my posts starting back in the beginning of this blog in March 2005.)

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Anonymous Don Lloyd said...


1. After the First World War, the government purposely inflated the money supply so as to finance the war effort. Instead of allowing that supply to deflate back to gold-standard measures, they chose to allow it to continue. Excess purchasing media therefore circulated throughout the next decade, creating the boom cycle that ended with the 1929 bust.

There can be no such thing as a reference level of purchasing media. Whatever quantity there is, prices will adjust to it. The fix for monetary inflation is not monetary deflation, but a cessation of further monetary inflation.

One of the great errors of the 20s was that when Great Britain tried to return to the gold standard after WWI, it tried to restore the pre-war gold price, effectively slamming the brakes on their economy, and not being sustainable. (from memory)

Regards, Don

5:30 PM  
Blogger Katy said...

I disagree with you Don. There is such a thing as a reference level of purchasing media. It's just that the money managers can't locate it.

Let me clarify by steering you away from interpreting my rebuttal as an affirmation of a reference level of the dollar. No, this I am not saying. Any fiat monetary unit will vary, (1) relevant to the amount of purchasing media in circulation (i.e. not hoarded in central bank exchange funds or tucked away in the hands of people who like it more than they like their own currency); and (2) as a response to the market's evaluation of it as a speculative medium and as a reflection of its issuer nation's state of economic health.

What I am saying is that there is an optimum amount of purchasing media, and this is discovered through sound commercial banking. It is:

The sum total of the value of all production coming to market, to be shared by those that produced it; plus all bank capital and savings, checking and other types of money (cash) accounts; plus only the amount of credit that a conservative reserve banking system should create (ideally, gold and cash reserves being between 20-40%).

Unfortunately, all countries have abandoned this type of banking since the early 1900s. Today, when the money managers create more than the above-described optimum amount of purchasing media, you get bubbles and abnormal degrees of business cycle swings that can go from mild to devastating, to wit our current dilemma.

To say that prices will simply adjust is not true, as we have noticed throughout the last bubble. General CPI didn't start to move until way out in the boom part of the cycle. I think this is because business people have become wiser and haven't given in as quickly to the temptation to expand during easy credit; so the excess purchasing media creates bubbles. This time, it went into real estate, for reasons we won't go into here.

9:56 AM  
Blogger Katy said...


I accept only constructive commentary.

9:37 AM  
Blogger Independent Accountant said...

I was first exposed to the AIER in 1958 and have read its materials on and off since then. I read the EC Harwood book you refer to and agree with ECH. The creation of purchasing media in excess of current needs is the excess purchasing media. That the price level will adjust to this only means what we call "inflation" takes place. You can't create real value from excess paper.

4:00 PM  

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