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Chapter 22: Lessons of the Recession

It’s official! Long after everyone in America knew that we were in a severe recession, the private but semi-official and incredibly venerated National Bureau of Economic Research has finally made its long-awaited pronouncement: we’ve been in a recession ever since last summer. Well! Here is an instructive example of the reason why the economics profession, once revered as a seer and scientific guide to wealth and prosperity, has been sinking rapidly in the esteem of the American public. It couldn’t have happened to a more deserving group. The current recession, indeed, has already brought us several valuable lessons:

Lesson # 1: You don’t need an economist. One of the favorite slogans of the 1960s New Left was: “You don’t need a weatherman to tell you how the wind is blowing.” Similarly, it is all too clear that you don’t need an economist to tell you whether you’ve been in a recession. So how is it that the macro-mavens not only can’t forecast what will happen next, they can’t even tell us where we are, and can barely tell us where we’ve been? To give them their due, I am pretty sure that Professors Hall, Zarnowitz, and the other distinguished solons of the famed Dating Committee of the National Bureau have known we’ve been in a recession for quite a while, maybe even since the knowledge percolated to the general public.

The problem is that the Bureau is trapped in its own methodology, the very methodology of Baconian empiricism, meticulous data-gathering and pseudo-science that has brought it inordinate prestige from the economics profession.

For the Bureau’s entire approach to business cycles for the past five decades has depended on dating the precise month of each cyclical turning point, peak and trough. It was therefore not enough to say, last fall, that “we entered a recession this summer.” That would have been enough for common-sense, or for Austrians, but even one month off the precise date would have done irreparable damage to the plethora of statistical manipulations—the averages, reference points, leads, lags, and indicators—that constitute the analytic machinery, and hence the “science,” of the National Bureau. If you want to know whether we’re in a recession, the last people to approach is the organized economics profession.

Of course, the general public might be good at spotting where we are at, but they are considerably poorer at causal analysis, or at figuring out how to get out of economic trouble. But then again, the economics profession is not so great at that either.

Lesson #2: There ain’t no such thing as a “new era.” Every time there is a long boom, by the final years of that boom, the press, the economics profession, and financial writers are rife with the pronouncement that recessions are a thing of the past, and that deep structural changes in the economy, or in knowledge among economists, have brought about a “new era.” The bad old days of recessions are over. We heard that first in the 1920s, and the culmination of that first new era was 1929; we heard it again in the 1960s, which led to the first major inflationary recession of the early 1970s; and we heard it most recently in the later 1980s. In fact, the best leading indicator of imminent deep recession is not the indices of the National Bureau; it is the burgeoning of the idea that recessions are a thing of the past.

More precisely, recessions will be around to plague us so long as there are bouts of inflationary credit expansion which bring them into being.

Lesson #3: You don’t need an inventory boom to have a recession. For months into the current recession, numerous pundits proclaimed that we couldn’t be in a recession because business had not piled up excessive inventories. Sorry. It made no difference, since malinvestments brought about by inflationary bank credit don’t necessarily have to take place in inventory form. As often happens in economic theory, a contingent symptom was mislabeled as an essential cause.

Unlike the above, other lessons of the current recession are not nearly as obvious. One is:

Lesson #4: Debt is not the crucial problem. Heavy private debt was a conspicuous feature of the boom of the 1980s, with much of the publicity focused on the floating of high-yield (“junk”) bonds for buyouts and takeovers. Debt per se, however, is not a grave economic problem.

When I purchase a corporate bond I am channeling savings into investment much the same way as when I purchase stock equity. Neither way is particularly unsound. If a firm or corporation floats too much debt as compared to equity, that is a miscalculation of its existing owners or managers, and not a problem for the economy at large. The worst that can happen is that, if indebtedness is too great, the creditors will take over from existing management and install a more efficient set of managers. Creditors, as well as stockholders, in short, are entrepreneurs.

The problem, therefore, is not debt but credit, and not all credit but bank credit financed by inflationary expansion of bank money rather than by the genuine savings of either shareholders or creditors. The problem in other words, is not debt but loans generated by fractional-reserve banking.

Lesson #5: Don’t worry about the Fed “pushing on a string.” Hard money adherents are a tiny fraction in the economics profession; but there are a large number of them in the investment newsletter business. For decades, these writers have been split into two warring camps: the “inflationists” versus the “deflationists.” These terms are used not in the sense of advocating policy, but in predicting future events.

“Inflationists,” of whom the present writer is one, have been maintaining that the Fed, having been freed of all restraints of the gold standard and committed to not allowing the supposed horrors of deflation, will pump enough money into the banking system to prevent money and price deflation from ever taking place.

“Deflationists,” on the other hand, claim that because of excessive credit and debt, the Fed has reached the point where it cannot control the money supply, where Fed additions to bank reserves cannot lead to banks expanding credit and the money supply. In common financial parlance, the Fed would be “pushing on a string.” Therefore, say the deflationists, we are in for an imminent, massive, and inevitable deflation of debt, money, and prices.

One would think that three decades of making such predictions that have never come true would faze the deflationists somewhat, but no, at the first sign of trouble, especially of a recession, the deflationists are invariably back, predicting imminent deflationary doom. For the last part of 1990, the money supply was flat, and the deflationists were sure that their day had come at last. Credit had been so excessive, they claimed, that businesses could no longer be induced to borrow, no matter how low the interest rate is pushed.

What deflationists always overlook is that, even in the unlikely event that banks could not stimulate further loans, they can always use their reserves to purchase securities, and thereby push money out into the economy. The key is whether or not the banks pile up excess reserves, failing to expand credit up to the limit allowed by legal reserves. The crucial point is that never have the banks done so, in 1990 or at any other time, apart from the single exception of the 1930s. (The difference was that not only were we in a severe depression in the 1930s, but that interest rates had been driven down to near zero, so that the banks were virtually losing nothing by not expanding credit up to their maximum limit.) The conclusion must be that the Fed pushes with a stick, not a string.

Early this year, moreover, the money supply began to spurt upward once again, putting an end, at least for the time being, to deflationist warnings and speculations.

Lesson #6: The banks might collapse. Oddly enough there is a possible deflation scenario, but not one in which the deflationists have ever expressed interest. There has been, in the last few years, a vital, and necessarily permanent, sea-change in American opinion. It is permanent because it entails a loss of American innocence. The American public, ever since 1933, had bought, hook, line and sinker, the propaganda of all Establishment economists, from Keynesians to Friedmanites, that the banking system is safe, SAFE, because of federal deposit insurance.

The collapse and destruction of the savings and loan banks, despite their “deposit insurance” by the federal government, has ended the insurance myth forevermore, and called into question the soundness of the last refuge of deposit insurance, the FDIC. It is now widely known that the FDIC simply doesn’t have the money to insure all those deposits, and that in fact it is heading rapidly toward bankruptcy.

Conventional wisdom now holds that the FDIC will be shored up by taxpayer bailout, and that it will be saved. But no matter: the knowledge that the commercial banks might fail has been tucked away by every American for future reference. Even if the public can be babied along, and the FDIC patched up for this recession, they can always remember this fact at some future crisis, and then the whole fractional-reserve house of cards will come tumbling down in a giant, cleansing bank run. To offset such a run, no taxpayer bailout would suffice.

But wouldn’t that be deflationary? Almost, but not quite. Because the banks could still be saved by a massive, hyper-inflationary printing of money by the Fed, and who would bet against such emergency rescue?

Lesson #7: There is no “Kondratieff cycle,” no way, no how. There is among many people, even including some of the better hard-money investment newsletter writers, an inexplicable devotion to the idea of an inevitable fifty-four-year “Kondratieff cycle” of expansion and contraction. It is universally agreed that the last Kondratieff trough was in 1940. Since fifty-one years have elapsed since that trough, and we are still waiting for the peak, it should be starkly clear that such a cycle does not exist.

Most Kondratieffists confidently predicted that the peak would occur in 1974, precisely fifty-four years after the previous peak, generally accepted as being in 1920. Their joy at the 1974 recession, however, turned sour at the quick recovery. Then they tried to salvage the theory by analogy to the alleged “plateau” of the 1920s, so that the visible peak, or contraction, would occur nine or ten years after the peak, as 1929 succeeded 1920.

The Kondratieffists there fell back on 1984 as the preferred date of the beginning of the deep contraction. Nothing happened, of course; and, now, seven years later, we are in the last gasp of the Kondratieff doctrine. If the current recession does not, as we have maintained, turn into a deep deflationary spiral, and the recession ends, there will simply be no time left for any plausible cycle of anything approaching fifty-four years. The Kondratieffist practitioners will, of course, never give up, any more than other seers and crystal-ball gazers; but presumably, their market will at last be over.

[Reprinted from The Free Market (July 1991).]