What the Economic Crisis Holds in Store

by Larry Smith

"The most we can say is that there has been a general lack of judgement...We have learned that we are not so big as we thought we were." -- Former US president Calvin Coolidge on the Great Depression

Ironically, the gloomiest economic doomsayers of today are often the staunchest advocates of free market capitalism. And one of them was in town last week to speak at a public meeting organised by the Nassau Institute.

Dr Robert Murphy is an economist who works for a plethora of libertarian think tanks in the US. At the Nassau Institute meeting, he offered a devastating critique of current American policy, touching briefly on the likely fall-out for the Bahamas from the current economic crisis.

In his view we are all in this recession for the long haul (read 10 years or more), and we are very likely to suffer the kind of stagflation last experienced in the 1970s - only squared. According to Murphy, US government policies are destroying the dollar and setting us all on a course towards hyperinflation.

Murphy is the author of the Politically Incorrect Guide to the Great Depression and the New Deal, which insists that the greatest economic disaster of the 20th century was caused by government interference with the free market, and led inexorably to a 'central planning' assault on liberty.

This is, of course, a favourite talking point among conservative economists, who believe that the "official" history of the 1930s is fake. Their revisionist account not only seeks to demonise US President Franklin Roosevelt, but argues that his 'big government' policies only made the Depression longer and worse - just as President Obama's policies promise to do today.

Economic Benchmarks
The scale of the Great Depression is familiar to most of us by now. It featured an unprecedented fall in stock values, a 28 per cent drop in economic output, unemployment that peaked at 28 per cent, and a near collapse of the banking system. Other countries fared as badly as the US, and world trade plunged by more than half. Nothing like this had ever happened before or since - until now.

The Depression began with a stock market crash in 1929 that led directly to Roosevelt's landslide election in 1933. His New Deal went on to change the face of American government, creating new institutions like the Securities and Exchange Commission to regulate the stock market, the Federal Deposit Insurance Corp to insure savings accounts, and Social Security to provide a safety net for the elderly.

According to Murphy and his libertarian colleagues, the Depression was caused by the US central bank flooding the market with easy credit, which artificially pushed down interest rates. Lower rates exaggerated the feeling of prosperity that had developed during the Roaring 20s, which produced an unsustainable boom that crashed in 1929.

In this view, recessions are caused by financing loans over and above the amount of money that is available from real savings, which creates a boom. And government efforts to delay the inevitable bust by stimulating demand and keeping credit inflated only make things worse.

This runs counter to the views of that influential British economist John Maynard Keynes (who died in 1945). He stated that, in the midst of an economic depression, the correct course of action is to encourage spending and discourage saving.

Tracing the origins of the current crisis, Murphy said that after the dot.com crash of the early 2000s, the US central bank under Alan Greenspan began pumping up the money supply. This easy credit created the housing bubble, which led to our present predicament. In other words, low interest rates caused people to save less and consume more, creating a false prosperity followed by a crash.

So what should we do about it? Basically nothing, Murphy says, and let the chips fall where they may, which is what the US government supposedly did in every economic slump from 1819 until the Great Depression. Unfortunately, this overlooks the fact that it is politically impossible for any modern, elected government to simply do nothing in the face of an economic downturn.

World Economy Tanking
Until recently, the consensus was that while things are bad today, they are not as bad as they were during the Great Depression. But a widely circulated analysis by two leading economic historians shows that the world economy - in terms of industrial production, trade and stock markets - is now tanking even faster than it did in the first year of the Great Depression.

Barry Eichengreen of the University of California, and Kevin O’Rourke of Trinity College, Dublin, date the beginning of the current global recession to April, 2008 and their research demonstrates a close match with the first year of the Great Depression. Using monthly data up to April 2009, they find no clear signs of ‘green shoots’.

In their paper for the London-based Centre for Economic Policy Research, they show that the global decline in output over the last nine months has been at least as severe as in the same period following the 1929 peak. The fall in the US stock market has tracked 1929, but global markets are falling even faster. And world trade is falling much faster now than in 1929-30.

"Globally, we are tracking or doing even worse than the Great Depression," they wrote, "whether the metric is industrial production, exports or equity valuations. Focusing on the US causes one to minimise this alarming fact. The 'Great Recession' label may turn out to be too optimistic. This is a Depression-sized event."

However, their research also shows that while fiscal deficits expanded only modestly after 1929, the willingness of governments to follow the advice of Keynes and run big deficits today is much greater. The question is whether this unprecedented policy response in the form of massive government stimulus programmes will work. 

The alternative outcome - as Murphy insists - is that it will produce unsustainable levels of public debt leading to a loss of confidence in monetary stability that will usher in a new era of "malign stagflation". This is a term coined in the 1970s to describe runaway inflation combined with stagnant business activity and rising unemployment.

Preparing for the Worst
Murphy himself is preparing for the worst. He wants interest rates to soar to levels that reflect the true price of capital, and workers in the most affected economic sectors left to fend for themselves and find new jobs in more productive areas. This is quite the opposite of Keynesian prescriptions to boost public spending when private sector investment declines.

"The current US government policies to freeze the economy by propping up failing companies are perverse," Murphy told the Nassau institute. "They are simply trying to reflate the bubble. What we need is to cut consumption and save more in order to readjust. in other words, we have to live below our means."

Murphy points out that the US is now forecasting trillion-dollar deficits for the next 10 years, and federal debt has topped $11 trillion - more than 82 per cent of gross domestic product. He is appalled that the US government now owns large portions of several major banks as well as auto makers, and wants to control the healthcare and energy sectors too.

"This is a huge power grab and move towards central planning, so I am very pessimistic about the economic outlook for the next 10 years."

Turning to the Bahamas, he said the government's ideas for revenue reform were good, although he deplored the introduction of unemployment insurance: "Paying people not to work only perpetuates the problem. Subsidizing unemployment will stall the recovery. Workers must be encouraged to find new employment in more productive sectors."

Again, this is opposite to what mainstream economists would advise. In its recent report on the Bahamas, for example, the International Monetary Fund said increased social spending through the National Insurance Board "to protect the most vulnerable Bahamians", and public infrastructure investment projects "to sustain employment in the construction sector", are appropriate. But the IMF, too, is worried about rising debt.

For the past decade the Bahamian fiscal deficit has averaged around 2 per cent, while public debt levels as a percentage of GDP have remained relatively low. Since mid-2008, however, the global downturn has caused our economy to shrink rapidly, with preliminary figures showing unemployment topping 14 per cent this spring. Without more taxes or spending cuts, government debt will rise to unsustainable levels within a few years, the IMF says.

Exit Strategies
This is the same conclusion the Fund drew about the American economy. It urged the US government to reassure markets about its stimulus exit strategies, and said fiscal policy  would need to be tightened by $700 billion a year from extra taxes or lower spending. The fiscal deficit in the US is expected to reach almost 14 per cent of GDP.

The IMF believes the Bahamian currency should remain pegged to the US dollar in order to promote a "stable investment climate." But Murphy's prediction that American prices will rise at double digits argues for a reconsideration of this link. Since most of our imports are from the United States, Murphy says we will suffer the same hyperinflation as the US.

That means prices rising at more than 50 per cent a month, which would wipe out both private and public purchasing power. So Murphy is building a stock of gold and silver coins as a hedge of last resort to weather the storm he believes is coming. And he is not alone. As the US government continues to pump money into the economy, many investors have started to worry about inflation.

According to Murphy the stakes are high. In his 'politically incorrect' book he argues that the economic crisis was caused by Americans living beyond their means - which they were encouraged to do by a reckless government. And he says the government's trillion-dollar stimulus package and related handouts will saddle taxpayers with more government debt than at any time since the Second World War.

Whether or not a collapse of the world as we know it is in store, there is no doubt that we are in for a very rough ride. In January, Carmen Reinhart of the University of Maryland and Kenneth Rogoff of Harvard University produced a key paper for the non-partisan National Bureau of Economic Research that focused on what happens after a severe financial crisis.

They found that, historically, such crises show deep and lasting effects on asset prices, industrial output and employment extending out over several years. And the real value of public debt tends to explode due to a collapse in tax revenues as well as to fiscal policies aimed at mitigating the downturn.

Whether or not you accept Murphy's views, it seems clear that none of this will play out in the short term, and we can expect many lean and difficult years ahead. We should use them as an opportunity to achieve vital structural reforms in the Bahamian economy to leave a worthwhile legacy for our children.

Comments

[Geoff Treco]

I did not come to the lecture. but I am not surprised to see what you wrote about his views.

I am a cynic with regard to the revisionists concerning the great Depression and to join that attitude together with the Chicago school of thought aka Friedman Economics...well the result is predictable.

I believe that the economic problems that are currently being experienced in the US have their genesis with the tragic Bush years.
Its difficult to point to one cause or event. I suggest that it was a confluence of events some of which I list below.

1. The Bush tax cut for the top 5% of US taxpayer
2.The Tragic mistake of the Iraq war.
3.The bush lack of planning to finance the war and adjust Federal spending to allow the tax cut to the wealthy without large deficits.
4.Poor oversight and regulation of US banking practices.

Mr Bush was intellectually weak and chose advisors that were idealogues rather than advisors that were practical and problem solvers.

Mr. Bush never made it from the Texas governor that he was to a President that should have been able to deal with the realities of the US as a modern and complex society.

His hands-off approach to the US economy, based on ideology, rather than a practical consideration of the consequences of large deficits and unregulated financial activity is largely responsible for the current mess.

Mr. Murphy would do nothing to solve the problems now being experienced. He has a secure Job and so the downturn is not a concern. But what do we do about the unemployed in the meantime?

[larry smith]

Well, I am increasingly agnostic on these matters. And we should all be concerned about rising debt. I just do not think the world's complexities can be reduced to the black and white terms presented by ideologues - of the left or the right. And I speak as a former hard-left socialist myself.

[Rick]

I agree with Mr. Treco that Bush's monetary policies were bone-headed, and Mr. Murphy thinks the Obama monetary policies,commonly being referred to as Bush on Steriods, are also bone-headed.
The debt is frightening and we will face the same thing here if our debt and deficits are not controlled.