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"Understanding the Great Depression & the Modern Business Cycle"
 by Dan Blatt - Publisher of FUTURECASTS online magazine

AT LAST! An analysis of the fundamental causes of the Great Depression and the current business cycle without ideological clap trap, theory confirmation bias or political spin.

Don't let yourself be caught by surprise by this Obama-Bernanke boom and bust cycle! 

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Table of Contents & Introduction

UNDERSTANDING THE CREDIT CRUNCH

Unprincipled Political Hacks & Keynesian Madness

FUTURECASTS online magazine
www.futurecasts.com
Vol. 12, No. 10, 10/1/10

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The Credit Crunch: 

 The markets clearly failed to discipline their participants during the bubble mania prior to the Credit Crunch recession, Washington liberals and Keynesians correctly assert.
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Typically, the reform effort includes establishment of vast portions of the left wing agenda that will burden the economy for the indefinite future.

 

Beyond any peradventure of a doubt, it was Republican economic policies that were the primary causes of the Credit Crunch, something they are understandably loath to admit.

  This clearly calls for new efforts at market regulation and the establishment of administered alternatives to the failed market mechanisms, they incorrectly assert. Typically, these reform efforts are conducted without any effort to analyze why the markets failed. Typically, there is left wing acceptance of  market failure as a natural process in market systems. Typically, the reform effort includes establishment of vast portions of the left wing agenda that will burden the economy for the indefinite future.
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  The Republicans are in no position to counter the liberal propaganda myths since, beyond any peradventure of a doubt, it was Republican economic policies that were the primary causes of the Credit Crunch, something Republicans are understandably loath to admit. The Republican congressional delegation during the Bush (II) administration proved themselves to be predominantly a bunch of unprincipled political hacks. They heedlessly and irresponsibly abandoned the successful economic policies of the 1980s and 1990s in their ardent looting of the public treasury and the disabling of the market disciplinary mechanisms that their supporters found inconvenient. FUTURECASTS readers have been kept abreast of this deplorable record since as early as October of 2002.See, "Heedless Government," "Government by Crisis," "Congress: The Engine of Inflation,"
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  Markets are indeed never perfect, right wing propaganda to the contrary notwithstanding. Men are not angels. Market activities are conducted by men who are far from perfect. The incentives of agents and their principals are never perfectly aligned. The temptation to take financial risks with borrowed money is always present in the markets. The business cycle is thus an unavoidable and indeed essential aspect of prosperous market systems. See, Blatt, "Understanding the Great Depression and the Modern Business Cycle" (2009). Table of Contents and Introduction.
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  However, the markets have powerful disciplinary processes that channel market activities along prudent lines. They have powerful recuperative powers that make them naturally resilient. Marxists and Keynesians stupidly refuse to acknowledge these processes. Only government policies of incredible stupidity can undermine these market mechanisms. Only governments can cause chronic inflation or Great Depressions. 
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  What undermined these essential market mechanisms during the Bush (II) administration of the first decade of the 21st century?

Moral hazard may be innocuous when government guarantees are limited to small depositors in regulated banks, but when guarantees extend to major investment banks and other major institutions they destroy the disciplinary function of the credit market vigilantes.

  • Creditors are supposed to be credit market vigilantes. Prudent lending practices are produced by balancing the desire for higher yields with the fear of default.

  Creditors are supposed to channel capital away from borrowers that take outsized risks with borrowed capital and insufficient equity. Borrowers with risky business models and leverage of 30-to-1 or 40-to-1 should be refused credit or required to put up adequate collateral and accept adequate conditions and pay very high interest rates.
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  However creditors are transformed into credit market enablers
when the taxpayers, poor schnooks, are expressly or impliedly made the guarantors for the repayment of loans. Moral hazard may be innocuous when government guarantees are limited to small depositors in regulated banks, but when guarantees extend to major investment banks and other major institutions they destroy the disciplinary function of the credit market vigilantes. Fannie Mae and Freddie Mac retained AAA credit ratings despite leverage of 50-to-1 and massive investments in subprime mortgages.
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  Today, government "too-big-to-fail" guarantees undermine credit market disciplines broadly. The right to fail is every bit as vital to the proper functioning of market systems as the right to succeed. Regulatory substitutes for this mechanism will inevitably prove costly and of limited effectiveness.

After several years of artificially low interest rates, the economy naturally adapts to the low interest rate environment. Business models become dependent on the availability of credit at low interest rates. 

  • Interest rates are among the most important disciplinary factors involved in properly allocating financial resources. They apply the time cost of money to financial decision making.

  However, artificially low interest rates maintained for years at a time by the Federal Reserve distort the time cost of money calculation, inevitably with vast unintended consequences. This may not be so bad when restricted to a few months or a year during some crisis period, but politicians love artificially low interest rates and have frequently successfully pressured the Federal Reserve to maintain them for several years at a stretch.
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  After several years of artificially low interest rates, the economy naturally adapts to the low interest rate environment. Business models become dependent on the availability of credit at low interest rates. During such periods, the ethically challenged find it much easier to erect houses of financial cards. Bubble mania frequently blossoms exuberantly.
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  The incentive to take large risks with borrowed money is always powerful, but low interest rates add competitive pressures and increase the incentive to almost irresistible levels. Leverage increased broadly in the years after the dot com bust. The economy thus did not fare well when the Fed was forced by rising rates of price inflation in 2007 to allow interest rates to rise towards market levels.  Artificially low interest rates had fueled credit bubbles as well as numerous houses of financial cards that were inevitably revealed and frequently collapsed when rates rose. The rest, as they say, was history!
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  Since the creation of the Federal Reserve System, this phenomenon has been repeated several times. The results were dramatically evident during the 1920-1921 recession, the 1937-1938 relapse of the Great Depression, the 1980-1982 recession, and most recently during the Credit Crunch recession of 2007-2009.
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  Indeed, almost all of the numerous recessions presided over by the Federal Reserve, including the Great Depression, have followed after some period of artificially low interest rates. The disciplines of market interest rates are far from perfect, but there is no adequate regulatory or administered substitute. See, Meltzer, "A History of the Federal Reserve," vols. 1 and 2, presented in eight articles beginning with Part I: "The Search for Monetary Stability (1913-1923)."

The government determinedly refuses to acknowledge its role in the housing inventory glut and continues to allocate additional resources into the housing market in the hope of inflating a new housing bubble.

  • The basic balance of supply and demand is perhaps the most important of the market disciplinary factors. However, when government allocates massive resources into favored markets, it obviously nullifies this factor. Massive allocation of financial resources into housing and agricultural markets leave these markets prone to production bubbles and chronic oversupply problems.

  The housing inventory surplus is the primary factor in the Credit Crunch recession. A housing inventory glut is by its nature far more difficult to liquidate than the ordinary supply inventory gluts that occasionally occur during a normal business cycle. Despite massive Keynesian deficits and monetary inflation, economic recovery unsurprisingly remains disappointing pending reduction of housing inventories back to the normal four months supply level. Agricultural surpluses and closed agricultural markets in many advanced nations undermine vital foreign policy objectives.
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  The government determinedly refuses to acknowledge its role in the housing inventory glut and continues to allocate additional resources into the housing market in the hope of inflating a new housing bubble. After all, each congressional district has developers and real estate brokers who provide political contributions, and each small agricultural state has two senators due to a Constitutional compromise that was absolutely essential to the formation of the Union.

Ignored are the high levels of taxation, liability risks, regulatory burdens and mandates imposed on the equity capital needed for economic stability and resiliency. The regulatory effort is thus essential but doomed.

 

Dividends  must be recognized as a deductible cost of raising and maintaining equity capital.

  • The tax statute is an economic abomination, full of noxious incentives that undermine normal market mechanisms. The objective of raising revenues in the least burdensome manner possible inevitably takes a back seat to the objectives of the social engineers and the political desire to provide tax favors for the politically influential. The heavier the tax burden, the more damage these noxious incentives cause.

  The tax preferences for debt capital, for one prime example,  powerfully induce excess leveraging throughout the economy. Through regulation, government now strives to increase capital adequacy requirements for financial institutions. However, ignored are the high levels of taxation, liability risks, regulatory burdens and mandates imposed on the equity capital needed for economic stability and resiliency. The regulatory effort is thus essential but doomed.
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  Dividends  must be recognized as a deductible cost of raising and maintaining equity capital just as interest payments are recognized as a deductible cost of raising and maintaining debt capital. Without this, corporations are forced to increase their leverage risks and managers are forced to expand into over-served markets or markets outside their competencies in their efforts to provide capital gains instead of dividend returns on investment. The deductions for dividend recipients that are sometimes provided as political favors are not adequate substitutes.
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  The economic distortions of just this one factor are enormous. Economic recovery at present would be far more certain and robust if corporations distributed larger dividends instead of hoarding cash in the hope of using it to generate capital gains later.

Ultimately and repeatedly, the Federal Reserve fails at all of its objectives and is paralyzed by a financial morass that it has helped generate.

 

Government policies have disabled one market disciplinary mechanism  after another.

  • Conflicting objectives are loaded upon the Federal Reserve. Maintaining the purchasing power of the dollar and acting as lender of last resort for solvent but temporarily illiquid banks are the primary and most vital objectives of the Federal Reserve, but congressional pressures always put conflicting political objectives ahead of these primary financial objectives. Ultimately and repeatedly, the Federal Reserve fails at all of its objectives and is paralyzed by a financial morass that it has helped generate.

  Federal Reserve express and implied responsibilities have been extended to maintaining low unemployment levels, maintaining low interest rates, allocating credit into the housing market, moral hazard guarantees of the credit of too-big-to-fail economic entities, extending lender of last resort facilities broadly throughout the financial system and even for propping up other types of insolvent institutions. No wonder the Fed has been repeatedly paralyzed after contributing to major financial breakdowns, as in 1929, 1932-33, 1979 and 2008. In each instance, the purchasing power of the dollar was among the objectives most readily sacrificed.
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  In short, government policies have disabled one market disciplinary mechanism  after another. If you break two of a dogs legs, the animal will stumble. You can reduce the stumbling by helping the animal heal the injured legs, which is a lengthy and difficult process - or by breaking the other two legs so that the dog doesn't move at all.
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  So, what is to be done?  We do know how to heal this dog.
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The Bush (II) and Obama policies have already dug so deep a hole that it will take a serious program of monetary austerity and its attendant recession to get out of it.

 

Keynesians provide only authoritative misinformation.

  The successful economic policies of the 1980s and 1990s must be restored, no matter how high a price must be paid in the short run. Don't forget, the nation had to suffer the severe 1980-1982 recession to even begin recovering from the Keynesian stupidities of the 1970s.
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  However, it is not politically possible for Obama to adopt a rational economic policy. The Bush (II) and Obama policies have already dug so deep a hole that it will take a serious program of monetary austerity and its attendant recession to get out of it. European countries are already attempting to bite this bullet, but Obama apparently has neither the political will - nor knowledge.
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  Recovery and prosperity during the 1980s and 1990s was achieved by permitting market interest rates to do what only market interest rates can do, by sharply constraining monetary inflation so that the dollar could regain its strength and status as the world's leading reserve currency, by reducing the federal budget deficit as the Cold War ended, by removing government regulatory constraints and facilitating market competition in major industries.
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  Above all, the politicians had to accept spending discipline that they hated, and the Keynesians had to be kicked out of Washington. Keynesian stimulus policies of budget deficits and monetary inflation ALWAYS fail. It is only a matter of time. Establishment economists clearly cannot forecast the failure of their own policies, so establishment economists no longer even pretend the competence to provide forecasts. As media contributors, they serve only to confuse and obfuscate.
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  Keynesians do not even pretend to provide testable hypotheses. Why should anybody have confidence in their economic policies if they cannot even forecast the results of their policies? Instead they provide "projections" that never survive the next turn of the business cycle and are of use only to impress the media and the credulous. They provide only authoritative misinformation.
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  In short, by doing everything opposite from what Keynesians promote, by constraining political expediency and ideological predilections, and by accepting the short term pain of the austerity period needed to undo the damage caused by political expediency and Keynesian policies, the U.S. market system readily restored economic prosperity, strength and predominance in the 1980s and 1990s. It is this history rather than economic theory that demonstrates the economic policies now needed.
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Near futurecast:

 

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  However, now entitlement problems are reaching critical levels. The insanity of putting major portions of the economy on autopilot without substantial constraints on costs threatens the nation's solvency.
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The drain on the budget from the entitlement programs will soon be massive.

  Now,  large numbers of baby boomers are beginning to retire. The critical moment has nothing to do with the draining of the "trust accounts." The trust accounts are just accounting fictions at best. The key moments come when these programs drain more funds from the budget than they add, when they begin to impose a fiscal burden instead of providing a fiscal surplus. The drain on the budget from the entitlement programs will soon be massive.
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  If government remains paralyzed in the face of this reality, California could again prove to be in the forefront of developments for the entire nation.
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This economy will not fare well when interest rates are again permitted to rise towards market levels - as eventually they must.

  Now, there have already been two years of artificially low interest rates. The economy is increasingly adapting to the low interest rate environment. Business plans are increasingly taking advantage of cheap loans. Incentives for the building of houses of financial cards - for taking major risks with borrowed funds - increase with every month that interest rates remain substantially below market levels.
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  Numerous economic and financial bubbles are already expanding exuberantly. This economy will not fare well when interest rates are again permitted to rise towards market levels - as eventually they must.
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Any gold bug who fails to warn of the need to get off the dance floor when the low interest rate music stops is dangerous to your wealth.

  Now, gold and other inflation hedges remain an essential part of every investment portfolio. Any economist, investment adviser or broker who does not advise the purchase of gold when the Fed pushes interest rates to such low levels is incompetent. There may be better investments available, but this is a no-brainer. If your broker and/or investment advisor did not advise purchase of gold or other inflation hedges in 2007 when interest rates were driven down, they are incompetent and you should drop them. The incompetence of economists who similarly failed to offer such obvious advice is similarly revealed.
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  However, inflation hedges are inherently bubbly. They require an itchy trigger finger. This is not a buy and hold investment. It will remain good only so long as the Fed persists in holding down interest rates. Any gold bug who fails to warn of the need to get off the dance floor when the low interest rate music stops is dangerous to your wealth.
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Ahmadinejad and Chavez joyously celebrate the return of the Keynesian plague to Washington.

  Now, the stock market is stuck in a broad trading range similar to that from 1966 to 1983. This is not a good market for simple buy-and-hold investors. Stock picking and market timing skills that few possess are unfortunately of increasing importance.
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  There will be major market moves up and down, but the top on the Dow will not at most go far above its old record high and the low will be as low as 6000. The low will probably not be reached until the austerity recession that will be required to overcome the impacts of current Keynesian policies.
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  Now, and for as long as budget deficits and monetary inflation
characterize U.S. economic policy, the U.S. dollar will trend lower, commodity prices will trend higher and precious metals will rise, U.S. financial strength and influence will deteriorate, and its adversaries will prosper and spread their influence across the globe - just as occurred during the 1970s. Ahmadinejad and Chavez joyously celebrate the return of the Keynesian plague to Washington.

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  Copyright 2010 Dan Blatt