Safehaven | Someone Tell Obama: Americans Did Not Cause the Financial Crisis, the World's Central Banks Did

April 05, 2009

Someone Tell Obama: Americans Did Not Cause the Financial Crisis, the World's Central Banks Did
by Gerard Jackson

Every economic bust demands scapegoats. And you can always bet your bottom dollar that politicians and journalists will be the ones leading the mob. (One need only recall the Democrats' recent efforts at whipping up hatred against bankers for confirmation of this dismal fact). But all said and done, you can never beat a good conspiracy story. And that is basically what Simon Johnson has given us. According to this brilliant student of economic history America is facing

elite business interests -- financiers, in the case of the U.S. -- played a central role in creating the crisis, making ever-larger gambles, with the implicit backing of the government, until the inevitable collapse. More alarming, they are now using their influence to prevent precisely the sorts of reforms that are needed, and fast, to pull the economy out of its nosedive. The government seems helpless, or unwilling, to act against them. (The Quiet Coup, The Atlantic, May 2009).

These sinister business interests have now formed a "financial oligarchy" whose political balance of power . . . gives the financial sector a veto over public policy". (And some of my readers still wonder why I am so contemptuous of journalists). Like the vast majority of his colleagues Johnson is completely ignorant of economic matters and of anything pertaining to the history of economic thought and economic history. (With respect to the latter the same can be said of the vast majority of economists and economic commentators). They have a saying back in Yorkshire: "Where's there's muck, lad, there's brass". Oddly enough this holds true for Johnson's article. Wading through the muck we come across the following details:

From 1973 to 1985, the financial sector never earned more than 16 percent of domestic corporate profits. In 1986, that figure reached 19 percent. In the 1990s, it oscillated between 21 percent and 30 percent, higher than it had ever been in the postwar period. This decade, it reached 41 percent. Pay rose just as dramatically. From 1948 to 1982, average compensation in the financial sector ranged between 99 percent and 108 percent of the average for all domestic private industries. From 1983, it shot upward, reaching 181 percent in 2007.

These are indeed very significant facts. But being a journalist Johnson found himself utterly inadequate to the task of discerning their importance. (In fairness to Johnson I must note that the conservative journalist Mark Steyn also failed to grasp their significance). Having approached his subject with the preconceived notion that there exists an extremely powerful "financial oligarchy" it became self-evident that these figures confirmed the power of this "oligarchy" to manipulate the economy to its own financial advantage. (Boy, this is nearly as good as the "Illuminati Conspiracy"). What Johnson -- and Steyn -- should have noticed from the charts below is that earnings and profits started their sustainable take-off in about 1980.

Source: The Atlantic

That Mr Johnson thinks these charts reveal something new and sinister is just a reminder of how ignorant and intellectually narrow-minded journalists can be. Roundabout 1734 Richard Cantillon wrote Essay on the Nature of Commerce in General in which he explained how inflation changes the pattern of production and incomes. The effect of inflation on the financial sector was noted in the French inflation that by 1720 had wrecked the currency. The South Bubble of 1720 was another example.

What we find is that not only do the number of purely financial transactions rise but a number of new financial activities and intermediaries also emerge. It becomes apparent that inflation creates financial imbalances that involve transferring wealth from one group of people to another group at the expense of wealth creation. As these financial dealings expand more labour is demanded. The Weimar inflation provides a graphic example of this process. From 1913 to the autumn of 1923 the number of bank employees jumped from 100,000 in 1913 to 375,000 in autumn 1923. As Constantino Bresciano-Turroni observed:

The increase in banking business was not the consequence of a more intense economic activity. The work was increased because the banks were overloaded with orders for buying and selling shares and foreign exchange, proceeding from the public which, in increasing numbers, took part in speculations on the Bourse. The banks did not help in the production of new wealth; but the same claims to wealth continually passed from hand to hand. (As Constantino Bresciano-Turroni, The Economics of Inflation: A Study of Currency Depreciation in Post-War Germany, John Dickens & Co LTD, 1968, p. 216).

Anyone who has taken the trouble to research this subject quickly becomes aware of how inflation corrodes moral values and subverts business ethics while engendering an irresponsible attitude to savings and speculation. Bresciano-Turroni certainly found this to be the case. As he wrote in his definitive study of the Weimar inflation:

At first inflation stimulated production . . . [then it] annihilated thrift; it made reform of the national budget impossible for years. . . it destroyed incalculable moral and intellectual values. It provoked a serious revolution in social classes, a few people accumulating wealth and forming a class of usurpers of national property, whilst millions of individuals were thrown into poverty. . . . it poisoned the German people by spreading among all classes the spirit of speculation and by diverting them from proper and regular work, and it was the cause of incessant political and moral disturbance. (Ibid. 404).

The malevolent effect of inflation on the pattern of incomes and wealth led to him to lament:

Inflation was always a terrible instrument for the redistribution of wealth (Ibid. 286).

Irrespective of the level of inflation the Cantillon effect always takes hold. Hence the view that "moderate inflation" is not only safe but healthy is a dangerous delusion. Therefore the greater the monetary expansion the greater will be the real and financial imbalances. The chart below shows how much M1 has expanded since 1960. It also shows that the growth in M1 started to accelerate at about the same time as salaries and profits began their rapid rise.

And who is responsible for this reckless monetary expansion? The Fed, of course. Yet we have the likes of Johnson creating a mythical "financial oligarchy" whose power exceeds that of governments. It was not some sinister cabal of financiers that inflated share prices and wrecked retirement accounts but the lousy monetary economics that the Fed and its fellow central bankers practise. As Machlup stressed 69 years ago:

... continual rise of stock prices cannot be explained by improved conditions of production or by increased voluntary savings, but only by an inflationary credit supply. (Fritz Machlup The Stock Market, Credit and Capital Formation, William Hodge and Company Limited, 1940, p. 290).

Those who blame deregulation and Bush for the crisis ignore the salient fact that Britain and the whole of Europe were swept by their own financial crisis. And one would have to be a complete political bigot to seriously assert that European banking was less regulated than its American counterpart. And this brings us right back to monetary expansion. Like the US Europe too has let loose with the monetary spigots as did China. The chart below reveals just how reckless the world's central bankers have been.

Compiled official global money supply data
was used to create the following chart

So how do our brilliant politicians and their economic advisors plan to solve the crisis? By pumping trillions of dollars into the world's monetary system. In other words, they intend to make the very same mistake again.

Gerard Jackson
BrookesNews.Com

Gerard Jackson is Brookes economics editor.