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It is very important to
distinguish between monetary inflation and a credit boom, or, contrarily,
monetary deflation and a credit bust. They are completely different. We
looked into this issue in the past, but it is worth mentioning again here,
especially as it appears we have just turned the corner from a credit boom to
a credit bust.
Monetary inflation and
deflation and purely monetary effects -- meaning, in essence, that they
result from changes in the value of currencies. The easiest and most reliable
way to measure changes in currency value is to compare the value of the
currency to gold. There are other indicators as well, for those who want confirmation.
Thus, if there was no
change in currency value, there was no inflation, and no deflation.
The credit boom we are
also all-too-familiar with now. "Easy credit" -- meaning primarily
low lending standards and high volumes of credit creation -- tends to create
economic activity and also probably increases in asset prices. This often has
a "reflexive" character, such that, as more credit is provided,
economic conditions get sunnier and sunnier and asset prices get higher and
higher. Typically, at some point, many loans will be made to low-quality
credits or against assets at unsustainable valuations. Then there is a credit
bust, as losses to lenders causes a change in lending conditions. This also
tends to have a "reflexive" character, as a restriction in credit
causes a depression in economic activity and typically lower asset prices,
which makes existing credits harder to service and lowers recoveries on
busted debt, all of which in turn leads to still further caution on lending.
It should be immediately
apparent that this credit cycle (and often a corresponding asset-price cycle)
can occur in an environment of stable, gold-linked currencies. Take, for
example, the Florida real-estate boom and bust of the 1920s. It took place in
its entirety while the dollar was linked to gold at $20.67/oz. No inflation
and no deflation.
Click here for a description of
the Florida real-estate boom of the 1920s.
It seems to be very
tempting for people to associate the boom period with monetary inflation, and
the bust period with monetary deflation. This is the "Austrian theory of
the trade cycle" in a nutshell, and at times it has validity.
Accompanying this idea is the notion that "banks are creating money from
nothing" during the credit expansion, which today is wholly untrue.
Banks don't create money. They are intermediaries who borrow from certain
parties and lend that money to others. This is apparent in their financial
statements, but should be obvious to anyone who has NOT ever found a dollar
bill printed by Bank of America or Citicorp. However, in the nineteenth
century banks did create money, literally printing paper bills. Often this
money creation happened alongside lending, so a bank would literally print
money from nothing and lend it out. The bills were redeemable for gold, which
kept things from getting out of hand as long as the redeemability
was reliable. Sometimes the redeemability wasn't
too reliable, and indeed banks created both a monetary inflation and credit
expansion simultaneously, in a single act.
I hope we can recognize
how much of today's rhetoric, especially "Austrian" rhetoric,
reflects the 19th-century environment it was developed in, even if those
conditions haven't existed for several generations. Unfortunately, a great
many people have become adept at repeating the rhetoric at what they feel are
appropriate times, without ever understanding the theory (correct or
incorrect) that lay behind the rhetoric many decades ago.
Now, typically at this
point there is an exhausting discussion about whether M2 or M3 or MZM or
god-knows-what constitutes "money", and whether thus a credit
expansion (these are essentially credit measures) is equivalent to a
"monetary" expansion, and whether this credit/monetary expansion
constitutes inflation, and so on and so forth. These discussions are all
pitfalls of using a quantity theory of money. We value theory guys simply
look at the value, and if the value hasn't changed, then there has been no
significant change in monetary (as opposed to credit) conditions. Actually,
the only money is base money, which is something like a manufactured good. All credit has a counterparty -- someone who has to
make good on a legal contract. Money -- paper bills essentially -- doesn't
have that quality. When you hold a $20 bill, nobody is legally liable for
anything. You can't go to court and say "you have to give me...",
well, what exactly? In essence, you "bought" the bill by trading
something valuable for it (typically employment labor or some other asset),
and you are stuck with it just the same as if you bought a toaster.
The quantity-theory guys
typically think they are very sophisticated in all of their endless
discussions of various forms of credit, but the fact that these discussions
have gone around and around for about a hundred and fifty years with no
conclusion should provide some hint that they are ultimately a dead end. The
picture is very clear for the value theorists, allowing them to come to a
definitive (and correct) conclusion without much effort.
Did the value of money
change? Well, there's your answer.
The inability to
distinguish between credit conditions and monetary conditions (which stems
from the inability to distinguish between money and credit to being with),
leads to all sorts of odd conclusions. There was certainly a credit boom
during the 1920s, for example, but there is no evidence whatsoever of
monetary inflation (falling currency value) of any real significance. The
dollar was comfortably pegged to gold, and indeed many dollars were made out
of gold, in the form of $20 bullion coins.
This confusion between
monetary inflation and credit expansion leads to another problem. Certain
"Austrian" types have taken up the traditional
classical/libertarian focus on monetary stability, which is all well and
good. In practice, this means a gold standard. The libertarian approach to
markets is basically hands-off, and thus if borrowers and lenders want to destroy
each other with silly credit, the libertarian allows them to do so, and
perhaps looks for a way to profit from the situation. However, by confusing
money and credit, many of today's self-proclaimed "Austrians" in
effect have taken up a focus on "stable credit," whatever that may
mean, instead of stable money. This is not necessarily a bad thing, as credit
busts can be very painful. However, this is a traditionally mercantilist
focus, and is a accomplished through what amounts to government coercion.
Let's take a specific
example. A great many people today blame two recent asset-price bubbles on
Alan Greenspan. The first was the TMT bubble of 1998-2000. Did the Fed cause
people to pay too much money for equities of TMT companies? Or to finance
kooky ideas that never went anywhere? Or to lend awesome sums for infotech buildout that didn't
produce cashflow? Certainly not. What people blame
the Fed for is not stopping this behavior. In short,
people blame the Fed for not exercising its powers of government coercion/manipulation!
Oddly enough, these Fed-blamers are often the same ones who want to make the
Fed disappear! Well, if the Fed didn't exist, then who would exercise the
powers of government coercion/manipulation? At the time, Alan Greenspan
argued that the Fed's proper role is to manage the money, i.e. avoid
inflation and deflation. What people did with the money, such as lend it to
loser ventures or use it to buy overpriced equities, was their own damn
fault.
I agree with Alan -- at
least in principle. In practice, Greenspan didn't really have the tools to do
what he wanted to do, and the dollar's value did rise to an uncomfortably
deflationary level during that period.
The second period was of
course the 2002-present period, corresponding to the real-estate bubble in
the US and also just about everywhere else as well. This is more complicated,
as the Fed was trying to do something about both the recession and monetary
deflation of 2001-2002, resulting in a very low policy rate target. And
indeed the value of money did change, going from deflationary to reflationary
to mildly inflationary to significantly inflationary. I won't get into the
heavy analysis of the period, but certainly nobody forced banks to make silly
loans to borrowers, and nobody forced borrowers to take them., and nobody
forced anyone to pay vastly more for properties than was justified by any cashflow metric. Certainly not the Fed. In that aspect,
it wasn't much different than the Florida boom/bust of the 1920s.
There are some
consequences to paying too much attention to credit booms and busts.
Sometimes a credit bust is really a reflection of economic bust. In new
economic conditions, such as a recession caused by higher taxes, credits that
would have been fine turn into bad credits. Thus, we should focus
on the new element, the higher taxes, rather than credit per se. It is all to easy to assume that the reason that credit goes bad is
because it was made in the first place. That, in other words, the cause of a
credit bust was an unsustainable credit "bubble" preceding. This
simplistic analysis thus serves as a replacement for finding out what was
really going on. For example, it seems to me that most of the commercial
lending in the 1920s period was probably pretty sound, and the reason much of
it eventually went bust was the dramatic change in economic conditions caused
by tax hikes worldwide, followed by monetary instability in late 1931.
Sometimes credit booms are just a natural phenomenon of a growing economy. A
conclusion from putting too much focus on credit, and blaming everything
under the sun on credit, is that one becomes very concerned about managing
credit, thus the tendency for certain "Austrian" types to lapse
into mercantilist credit-management arguments.
In practice, I find that
a credit boom/bust can indeed cause a recession, but these tend to be
relatively mild recessions within a context of a longer-term course of
economic improvement. There were several minor recessions in the 1950s and
1960s, for example, but these are remembered only by economic historians. We
remember the two decade period as one of general economic health. Korea
recently experienced a recession corresponding to a boom and bust in consumer
credit-card lending. It's over now, and nobody was too much hurt by the
situation. The century-class economic disasters like the Great Depression,
the inflation of the 1970s, the Asia Crisis, the disasters of Latin America
in the 1980s, and so forth, usually have taxes or monetary instability at their
root.
That is why I haven't
jumped up and down about the boom and bust in US real estate and credit
broadly speaking (including private equity, structured finance,
credit-related derivatives, commercial real estate lending, new rules on
margin for investment funds, etc), even though it is certainly the mother of
all credit/asset bubbles -- probably the biggest in all of US history in its
extremity and extent -- and hardly anyone is more bearish on the sector than
me. The natural result would be a recession, probably a very long and nasty
one, but not a century-class disaster of the 1930s/1970s variety. The real
danger that I see now is monetary inflation, which is already well on its
way, and likely to get worse as appetite for "hawkish," anti-inflationary
policies will pretty much disappear going forward. There doesn't seem to be
too much danger of dramatic tax hikes, although things are likely headed
toward higher taxes in the US as the Democrats become more influential.
I would say that most
commercial lending in the 1980s in Japan was probably OK as well. There was
certainly a credit bubble related to property, but so what. Even if this had
been followed by a bust, the losses suffered by banks and the economy as a
whole would have been much, much less and much, much shorter in duration if
a) there hadn't been probably the most intense monetary deflation ever
experienced in human history, and b) the government hadn't raised taxes on
real estate to silly levels, such as a 90% capital gains tax on property in
1991, which persisted until 1998, or a tenfold increase in effective property
tax rates. (Yes, sometimes people are that stupid. In fact, I would say that
they are pretty much that stupid all the time, with some exceptions.)
A second aspect of confusing
money and credit is that one becomes unable to understand the virtue and
value of a gold standard, which is to create stable money (money that is
stable in value). On the one hand, we have the Austrians, who blame the Great
Depression on "inflation," by which they seem to mean too much
credit in the 1920s. On the other hand, we have the Monetarists, who blame
the Great Depression on "deflation," by which they seem to mean too
little credit in the early 1930s. Both blame the Fed. The problem with both
approaches is that their followers tend to conclude that the gold standard
didn't work, as it caused either "inflation" or
"deflation," i.e. too much or too little credit, depending on which
side of the bed you get up that morning.
The gold standard did work,
of course. Money was stable in value. The problem wasn't unstable money. Even
if the problem was "too much" or "too little" credit --
which it wasn't, in my opinion -- there was nothing a gold standard could do
about it. Take out a gold coin. Do you see it making loans? It just sits
there ... inert ... stable.
The "Austrians"
and the Monetarists, between them, commanded most "conservative
"economic thinking over the past sixty or so years. The
"Austrian" approach to their conundrum, over the years, has been to
recommend all sorts of bizarre and exotic systems which they call a
"gold standard." Their fear of the consequences of credit busts are
so intense that, from time to time, they want to outlaw banking altogether!
Apparently all lending is tainted with sin in their opinion. (They don't do
this as much now, it seems.) "Never a borrower nor a lender be"
said Shakespeare, and historically that opinion has held quite a bit of
weight, whether in the form of the Christian edicts against usury that
prevented lending from the third to fourteenth centuries AD in Europe, or
Islamic banking rules today. Nevertheless, don't be surprised if people think
you're a super-kook today, if you go on about that
"fractional-reserve" banking stuff! The Monetarist approach has
been to ignore gold altogether -- the Monetarists advocated the end of the
gold standard in 1971 -- and instead follow their bizarre and exotic
monetary-quantity models. After the failed Monetarist experiment of the early
1980s, nobody takes those models too seriously anymore, so Monetarism has
devolved into little more than a theory of the Great Depression (still
popular) and some libertarian homilies about free markets, free trade and so
forth.
I like to focus on the Bretton Woods gold standard of the 1950s and 1960s. It
was a world not much different than today's, except that their money was
pegged to gold and they enjoyed a level of broad-based prosperity and
improvement that has eluded Americans since ... since we went off the gold
standard in 1971.
It may seem like I
quibble about credit and money, but I see people having struggled with this
matter for lo about eighty years now. The solution is actually quite simple,
and I hope by now that it seems so to you too.
Nathan
Lewis
Nathan Lewis was formerly the chief international
economist of a leading economic forecasting firm. He now works in asset
management. Lewis has written for the Financial Times, the Wall Street
Journal Asia, the Japan Times, Pravda, and other publications. He has
appeared on financial television in the United
States, Japan,
and the Middle East. About the Book: Gold:
The Once and Future Money (Wiley, 2007, ISBN: 978-0-470-04766-8, $27.95) is
available at bookstores nationwide, from all major online booksellers, and
direct from the publisher at www.wileyfinance.com or 800-225-5945. In Canada,
call 800-567-4797.
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