This month has seen something that happens not very often: it appears to
be the early stages of a global stock market crash.
For the moment investors are in shock, seeking reassurance and keenly
intent on preserving their diminishing assets, instead of reflecting on the
broader economic reasons behind it. To mainstream financial commentators,
blame for a crash is always placed on remote factors, such as China's
financial crisis, and has little to do with events closer to home. Analysis
of this sort is selective and badly misplaced. The purpose of this article is
to provide an overview of the economic background to today's markets as well
as the likely consequences.
The origins of a developing crisis are deeply embedded in the financial
system and date back to the invention of central banks, and more particularly
to the Bretton Woods Agreement, which was the basis of the post-war monetary
system. In the 1940s government economists were embracing the new Keynesian
view that Say's law, the law of the markets, was irrelevant and supply and
demand for goods and services could be regarded as independent from each
other, and crucially, savings should be redirected into immediate consumption
and replaced as a source of investment finance by a more flexible approach to
money and credit.
Keynes wanted a new super-currency, which he called the bancor. Instead the
world got the dollar and the "full faith and credit" of the US
government expressed through her considerable gold reserves. While central
banks could swap dollars for gold at $35 per ounce, there was no effective
restraint on the issuance of dollar-money and credit. It allowed America to
finance the Korean and Vietnam wars without resorting to domestic taxation.
When those dollars-for-export returned home in the late sixties, the run
against dollars and in favour of gold began, leading to the Nixon Shock, when
the US finally consigned the Bretton Woods Agreement to the dustbin of
history.
From the 1970s the dollar continued in its role as the world's reserve
currency without any gold convertibility at all. As a deliberate policy the
US government tried to remove gold's status as money by simply denying it had
any such role. The propaganda persists to this day, expressed as progress in
the development of government-issued currencies. Having thus disposed of the
shackles of sound money, money and credit were expanded to pay for sharply higher
oil prices in the early 1970s, and made available for Latin American
borrowers without meaningful constraint. This was followed by an accelerating
loss of the US dollar's purchasing power in the second half of that decade.
The expansion of money and credit since Bretton Woods corrupted business
calculations in the same way as fractional reserve banking had done over the
previous hundred years, but with the additional feature of unfettered
expansion of raw money. Instead of periodic banking crises, which liquidated
bad and excessive debts, banks were supported and debts were allowed to
accumulate over successive credit cycles. Not even the increases in interest
rates in the late-seventies, designed to halt runaway price inflation, saw
total debt contract.
The consequences of these monetary and credit excesses up to the end of the
last century were growth in financial speculation. This culminated in the
dot-com boom, which was on a similar bubble-scale to the stockmarket excesses
of 1927-1929, and arguably was fuelled by the same degree of public
speculation recorded in the Mississippi and South Sea bubbles three hundred
years ago. Stock markets were only rescued from the subsequent fall-out by
the unprecedented actions of the Fed in 2001-2003, which reduced the Fed
Funds Rate to 1%, laying the foundations for the housing bubble of 2005-2007.
And as we all know, it was the collapse of this secondary bubble that led to
the financial crisis that took down Bear Stearns and Lehman Bros.
According to the McKinsey Global Institute, global debt increased from $142
trillion in 2007 to $199 trillion at the end of 2014. This was admittedly a
slower rate of growth than 2000-07, but the difference can be accounted for
by the expansion of central bank base money and the higher average level of
rolled-over interest rates during the earlier period. Separately,
shadow-banking debt has also grown as a source of short-term financing. It
remains the case today that financial instability is the consequence of
excessive debt, and the global financial system is inherently more risky
today than it was at the time of the Lehman Crisis.
Reliance on debt as an economic driver is the other side of the expansion of
the total quantity of money. This can only continue so long as people accept
that money maintains its objective exchange-value.
Interest rates
Since the late 1970s the major central banks, led by the Fed, have wrested
control of interest rates from markets on the supposition that economic
activity and price inflation can be managed by varying them at the state's
behest. The policy is very different from the way interest rates are set in
free markets. The philosophical bias behind state management of interest
rates, that borrowers are more deserving than lenders, has a long history,
dating long before Shakespeare's Shylock. Since central banks have controlled
interest rates they have always favoured borrowers over savers, with the
predictable result that global debt has expanded without the underlying
production to support it. And without earnings set aside from production,
debt cannot be repaid, so it must default.
Preventing this default has become a growing problem and is the primary task
facing central banks. Household, corporate, government and financial sectors
are all exposed to debt default, ensuring political and business
considerations will allow no alternative outcome. The only means central
banks can employ is the creation of yet more money, and to foster the
expansion of bank credit at an ever-increasing pace, a remedy that was
spectacularly confirmed as effective by the Fed's management of the Lehman
crisis and the rounds of quantitative easing that followed. Zero interest
rates have ensured that compounding unpaid interest is kept to a minimum, but
at the same time they have encouraged yet more unproductive borrowing.
Markets are signalling that we are arriving at a new financial crisis, and
soon it will be time to unleash the monetary weapon again.
Each crisis is of a greater magnitude than the previous one. The trigger
undermining the global debt problem this time is a sharp slowdown in global
production. Without the fig-leaf of increasing productive output, the
precariousness of the global debt problem has become all too evident to
ignore, even for perpetual optimists.
The inevitable conclusion
Equity markets are telling us that the debt crisis is now upon us again. The
detailed course that events will take from here cannot be predicted, but we
can be certain that over the coming months governments will be ready to move
heaven and earth to prevent a deepening crisis, by any means at their
disposal. In this respect the lesson of the Lehman crisis is that flooding
the system with money and guarantees of more money actually works. Gone will
be any pretence of monetary discipline, gone will be any pretence of higher
interest rates, and gone will be any constraint on the issuance of yet more
debt. A crisis of malinvestment has become a crisis of the financial system,
and will soon become a crisis of currencies. We can be increasingly certain
that debt will be extinguished not by debtors reckoning with creditors, but
by the debasement of money, and that this outcome becomes the unstated
objective of policy makers.
It is an important conclusion. In effect, it posits that the only solution
open to central banks is the deliberate destruction of their own currencies,
not on the drip-feed basis that has existed since the Bretton Woods
Agreement, but by a more deliberate acceleration. We cannot judge whether
this will work one more time, postponing a final crisis. But we can see the
circumstances ahead of us more clearly, and we can more easily imagine
central bankers being drawn into repeating the mistaken policies of Rudolf
Havenstein, president of Germany's Reichsbank in 1921-1923. In predicting
this final crisis for any country that treads down the path of government
corruption of its money, the economist von Mises described its manifestation
as a crack-up boom, the boom to end all booms, when ordinary people finally
realise the worthlessness of government currency and dump it as rapidly as
possible for anything they can get hold of. The last vestiges of the
currency's objective exchange-value evaporate.
The hyperinflation of fiat money and the prospect of a final collapse in its
purchasing power is becoming an increasingly probable outcome of the
financial events unfolding today. That much can be deduced from sound
economic theory, and is confirmed by historical records of similar crises. We
can also expect this outcome to be made certain by the misguided faux-science
of macroeconomics, which bases itself on the denial of Say's law and which
badly misleads government policy-makers.
Only this time the threatened currency destruction will be global, because
where the dollar goes, and the dollar is still the reserve currency, so we
all go.
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