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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Sunday, September 21, 2008

America's New-Found Socialism: The Mother of All Government Interventions

I have been having fun over the last few months citing examples of government intervention run amuck. This weekend, I think we've hit the motherload.

Hank Paulson has become the new symbol of American socialism at work. He, with the help of his colleagues Ben Bernanke and some legislators, has become what some are labeling the "bail-out tsar."

[Tweaked image taken from, who got it from]

The French leftist newspaper Liberation is labeling our country, once the symbol of the free market, the USSRA: United Socialist States of the Republic of America.

Yes, the free-market pretense seems to be over, folks. The chips are now on the table. Whatever happened to the so-called "Reagan Revolution"?

As one congressman describes it in a citation pulled from MarketNews International by Prudent Bear:

"U.S. Senator Jim Bunning today issued the following statement regarding the Treasury Department's bailout of Wall Street. ‘Instead of celebrating the Fourth of July next year Americans will be celebrating Bastille Day; the free market for all intensive purposes is dead in America. The action proposed today by the Treasury Department will take away the free market and institute socialism in America.'"

This would be true if it weren't for the fact that we've been creeping toward socialism since the First World War. This latest is only the most recent leftist push.

I suppose there is a slight chance that Paulson--who does know investment banking--might have played the taypayers' hand well. By this I mean that there may be a tiny possibility that the toxic waste he will be buying for us (if Congress gives him the power he seeks) could in the long run be worth more than the taxpayers will pay for it.

But why is it that I just don't believe that? Well, a look back at history tends to substantiate that whenever the government intervenes into the market, it mucks it up. It's just a rule of thumb. Why should this case scenario be any different?

(Don't sell your gold yet.)

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Saturday, September 13, 2008

The Ultimate Bail-Out

According to this piece of news from Qatar's news source The Peninsula, U.S. government officials are finding themselves in a squeeze.

They arranged the bail-out of Bear Stearns; then they nationalized Freddie Mac and Fannie Mae; now, they are surprised to see all eyes on them as Lehman Bros. flails in desperation.

[Thanks to for the image.]

They will have to do something again. They have signaled to the world that they will not let these "too-big-to-fail" companies die, even though they deserve to. Moral Hazard has finally erupted into the monster everyone warned it was going to be.

Officials can argue until the last financial institution croaks that the monetary system could not have withstood the pressure; but all they have done is parcel out the torture. To borrow a friend's expression, it's like cutting off the tail of a dog one joint at a time to save him the pain of losing the whole tail at once.

When will we learn that politicians cannot control economies, that government intervention is guaranteed to run amuk every time?

In the end, the biggest bail-out of all time will be sponsored by us all, the U.S. taxpayers. The working stiffs, the employed, the self-employed, pensioners, the forgotten hords, even the people on unemployment--we'll all be paying for this down the line, when we are called upon to bail out our government for having gotten us into so much debt.

This story isn't over yet, my folks. Real estate hasn't bottomed out yet; companies are not hiring; investment has slowed; credit is still tight (as it should be after so much looseness). We will be paying the bill for this one for years to come.

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Saturday, September 06, 2008

Freddie and Fannie Bail-Outs: The Denouement

You may recall my Example No. 17 of government intervention run amuck. I told you about the mess in which our mortgage industry finds itself, helped by our semi-governmental agencies, Freddie Mac and Fannie Mae.

We now have this piece by Deborah Solomon and Damian Paletta at the Wall Street Journal, giving us an update of their situation.

[Thanks to for this image.]

The bail-outs keep coming in this financial saga, and Freddie and Fannie will be no exceptions. A few months ago, Teasury Secretary Henry Paulson obtained our permission (through Congress) to bail them out, and apparently he didn't do it for nothing.

So now we have Government Intervention upon Government Intervention, both now running amuck in tandem. Not only was the very creation of these two organisms unwise, as I explain in my earlier post linked above; but now we have one more in the string of wrongs that government officials are having to commit in their effort to right the original one. To wit:

"Mr. Paulson's push to win authority was meant to reassure investors that the government wouldn't allow Fannie Mae and Freddie Mac to fail. But some believe it ultimately forced Treasury's hand. The federal government's involvement complicated the companies' already-difficult task of raising capital through the sale of common or preferred shares. Investors were leery of buying either while the government's intentions were unknown, because they feared the newly issued shares might become worthless as the result of federal action."

And look for more wrong runnings-amuck from this problem. For example, here's one I can see from a mile away:

"Among the issues with which Treasury has been wrestling is whether to make an investment at such a low price that shareholders are effectively wiped out. Mr. Paulson is cautious about any plan that appears to benefit shareholders because he doesn't want the government to be seen as bailing out investors who for years profited from the companies' success."

Bloomberg also gives their version of this news.

Ah, it would all be so entertaining if it were fiction.

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