Fighting the depression, losing the war
James Saft is a Reuters columnist. The opinions expressed are his own.
HUNTSVILLE, Ala. — If bank failures and deflation frighten you, we are managing the economy in the right way, but if you worry about drops in output and investment, we’ve not made much progress.
In other words, policy makers are very good at re-fighting the Great Depression, but may have simply reallocated the damage.
A study of the interaction of credit, the economy and financial crises by economists Moritz Schularick and Alan Taylor looked at the period between 1870 and 2008, casting a shadow over the usefulness of modern activist central banking.
“The impact of financial crises was more muted in the postwar era in absolute numbers, but of comparable magnitude relative to trend,” according to the study, authored in 2009 but presented last month at a conference hosted by the Atlanta Federal Reserve.
“Measured by output declines, financial crises remain severe in the post-1945 period. The maximum decline in real investment activity was somewhat more pronounced before WW2, albeit with a sharp bounce back after 4 to 5 years.”
Schularick and Taylor looked at 14 developed economies over the 138-year period, examining the growth of bank loans, bank assets and money supply and how they compared to overall economic growth. What they found is that credit creation has become unmoored from the creation of money, allowing for an ever larger banking system.
In an earlier era that ended in 1939, money and credit jumped around a great deal, reflecting the more laissez faire attitude of the authorities, but they tended to have a reasonably stable relationship to one another. That meant difficult periods of balance sheet contraction and deflationary pressure.
After World War II, however, bank assets and loans grew strongly relative to both the economy and to money supply. This happened, most likely, because banks leveraged up, borrowing heavily to lend more heavily than their deposit base would allow. Non-banks, such as investment banks, grew even more strongly, as we know.
Under our current system, much credit is created by the financial markets, giving them a more central role in the economy’s health but also making it subject to the whims and crazes of investors. This explains the Fed’s determination to support asset prices, but it also underlines the way in which the Fed, and the rest of us, are hostage to confidence and successive bubbles.
SHADOW OF THE DEPRESSION
Central bankers learned the lesson of the Great Depression, in that they eased more aggressively in the post-Depression period. That has meant that we’ve not seen the collapses in money supply and grinding deleveraging that characterized many old school recessions.
While that has arguably led to fewer failures in the financial system and has seen off long periods of deflation it actually hasn’t improved the economic impact of financial crises.
That may be unfair, partly because we don’t know how bad the modern-era crises would have been if the Fed and other central banks had not eased quickly and aggressively. After all, the more heavily financialized an economy is, presumably the worse a crisis centered in the banking system will become if no circuit breaker is applied.
That’s just where the madness of the current system becomes apparent; we ease to avoid a depression, but in doing so we fertilize the financial sector which grows so large that we are ever less able to face up to allowing it to suffer. Ultimately, as in 2008, we feel we have no choice but to apply blanket guarantees. The important point is that the financial system has not grown because it is successful, or based on demand, but because it enjoys protected and favored status.
All the while, at least based on the data, the damage to trend growth is about what it used to be. Interestingly, the data covers not just the highly banked English-speaking world, but many other economies as well, and is pretty consistent.
While the benefits of the system of insurance and Fed guarantee are questionable, some other effects are not. It has created a much larger financial sector in the U.S., as well as in the rest of the world, and this has grown alongside economic inequality. In this light it is wrong to look at growing inequality, and all it brings, and conclude that this is the result of a market system rewarding winners and punishing losers.
Increasing inequality may well be the fruit of a system of government intervention in markets, as whomever can get closest to the spigot of warm cash flowing from the government guarantees does best.
This system also, inevitably, breeds bubbles and crises which are tending to get larger and larger and which must eventually overwhelm states’ ability to underwrite them.
The fun is in guessing what the next bubble will be, but at some point that particular game will be up.
(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund.)